Innovative Industrial Properties, Inc. (NYSE:IIPR) Q1 2023 Earnings Call Transcript May 9, 2023

Innovative Industrial Properties, Inc. beats earnings expectations. Reported EPS is $1.43, expectations were $1.31.

Operator: Good day and welcome to the Innovative Industrial Properties, Inc. First Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Brian Wolfe, General Counsel. Please go ahead.

Brian Wolfe: Thank you for joining the call. Presenting today are Alan Gold, Executive Chairman. Paul Smithers, President and Chief Executive Officer, David Smith, Chief Financial Officer. Catherine Hastings, Chief Operating Officer and Ben Regin, Chief Investment Officer. Before we begin, I’d like to remind everyone that statements made during today’s conference call may be deemed forward-looking statements within the meaning of the Safe Harbor of the Private Securities Litigation Reform Act of 1995 and actual results may differ materially due to a variety of risks, uncertainties and other factors. Please refer to the documents filed by the company with the SEC. Specifically the most recent reports on Forms 10-K and 10-Q, which identify important risk factors that could cause actual results to differ from those contained in the forward-looking statements.

We are not obligated to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise. In addition, on today’s call, we will discuss certain non-GAAP financial information, such as FFO, normalized FFO, and adjusted FFO. You can find this information together with reconciliations to the most directly comparable GAAP financial measure in our earnings release issued yesterday as well as in our 8-K filed with the SEC. I’ll now hand the call over to Alan. Alan?

Alan Gold: Thank you, Brian, and welcome, everyone. We are pleased to report another solid quarter of operations and financial results, especially in the context of ongoing challenges in the macro economy that we are all experiencing. We believe we have positioned ourselves well in this context with one of the strongest and most experienced teams, our real estate professionals, in the cannabis industry, a high quality portfolio and arguably, a conservative and flexible balance sheet. With that, I’m also pleased to introduce our newest member of the management team on this call. David Smith, who joined us in late March as our new Chief Financial Officer. David brings a wealth of senior management experience in the real estate industry including cannabis real estate and publicly traded REITs in particular and we look forward to his insight and contributions to our company for many years to come.

With David’s appointment, we also promoted Catherine Hastings to Chief Operating Officer and Ben Regin to Chief Investment Officer, both seasoned executives that have been with us nearly from the start of the company. We are truly fortunate to have such a dedicated team and to expand our team with David’s caliber of talent. To recap the quarter, we generated total revenues of $76 million in Q1. Adjusted funds from operations of over $63 million, rent collection from IIP’s operating portfolio was 98% for the quarter. The financial performance combined to drive dividend returns to investors with a $7.15 of dividends declared per share in the past 12 months alone. While we’ve noted for the past several quarters that we expect investment activity to slow given the significant increases to funding costs that have taken place and overall macroeconomic headwinds.

I wanted to highlight our transaction with our new tenant, Battle Green during the quarter, where we acquired a 157,000 square foot industrial facility under development in Ohio and executed a long-term lease with Battle Green. Battle Green has a great leadership team in place and we see Ohio being one of the states poised to adopt an Adult-Use program in the near term. Including that transaction, we’ve committed over $90 million in additional investments year-to-date. Ben will provide further detail on our Battle Green transaction and other investment activities year-to-date. We continue to strive as we have from the very beginning to be as transparent in detail as we can about our business and prospects and hope all our shareholders feel the same.

On the positive side, we are seeing green shoots in the industry such as the reintroduction of the SAFE Banking Act, which Paul will spend more time discussing. Catherine Hastings, as I mentioned, will highlight our positive portfolio statistics including rent collection from the first quarter and for the first two months of this quarter. I will now turn the call over to Paul to discuss licensing industry dynamics. Paul?

Paul Smithers: Thanks, Alan. Before discussing overall market developments, I’d like to provide an update on the properties we previously disclosed last quarter where tenants Parallel and Green Peak have not paid rent. As we noted then and I think it is worth repeating here, we are of course first and foremost focused on maximizing the value of each of our properties and having tenants with strong teams that can manage their businesses successfully through inevitable ups and downs of this industry. We have engaged local counsel and other advisors in these situations, commence legal proceedings for damages and possession and are in discussions with applicable regulatory agencies. With our veteran team internally in combination with our advisors across a spectrum of specialties, I am confident in our ability to successfully navigate these situations.

As noted during our prior earnings call, we commenced litigation against Green Peak at our Summit property in Michigan. In early March, as many of you may know Green Peak was placed into receivership and in mid-March we regained possession of the Summit building. In addition, we regained possession of two small retail locations in Michigan previously leased to Green Peak for which our total investment is less than $3 million. Receivers paying rent on all other remaining properties leased to Green Peak including the harvest part cultivation and processing facility and four other retail locations. And we are closely monitoring the situation and receivership process. We are currently in the process of discussing and touring the Summit property with interested cannabis operators.

As noted in our prior call, we also filed actions against Parallel for possession and damages at our Pennsylvania property and our Texas property, which is in the early stages of development. We regained possession of the Texas property in mid-March, where Parallel failed to pay rent for the first time in February. We are actively exploring all options for these properties including speaking to a number of interested parties. As we noted previously, Parallel is current on the other two properties, we leased to them in Florida. And for Kings Garden, they continue to pay rent at the four properties they occupy and continue to explore a potential merger transaction. Market developments. While it is clear that the regulated cannabis industry has experienced in the past several months and continues to experience a set of challenging circumstances.

I would like to note that the growth of the overall cannabis industry in the United States is expected to continue to be strong. With industry research group, New Frontier Data projecting a doubling of annual sales from 2023 to 2030 to over $70 billion, representing a double-digit compound annual growth rate. The regulated cannabis industry remains an exceptional case of industry size and growth potential. As we’ve noted for some time now, unit pricing for regulated cannabis products have been challenged in certain states at the wholesale level, reflective of what we believe to be a number of factors including basic supply/demand dynamics, lack of meaningful enforcement in certain states on illicit, non-licensed cannabis sales by state and local enforcement authorities, taxation and general macroeconomic conditions.

Reflecting that continued price compression in combination with the continued inflation on input and labor costs. We note that consensus, analyst expectations for 2023 EBITDA have fallen significantly for publicly traded U.S. operators nearly across the board. That said, this price compression dynamic is certainly not uniform across states and we are cautiously optimistic that certain states like California may have turn the corner on the persistency of unit pricing declines, while new adult use states like Missouri are seeing very healthy wholesale pricing dynamics. Capital availability. Another continuing theme from our prior calls is the tightening of financial conditions and the impact it continues to have on capital availability for the cannabis industry.

As with other industries, the cost of capital and capital availability have fundamentally changed for cannabis operators over the course of the past year or so. As we noted previously, capital raising across the cannabis industry continues to be very subdued with rating and capital advisors reporting that U.S. operator capital raises were down 86% in Q1 versus the prior year period and of those raises nearly 90% was in the form of debt. From our perspective, we believe the present macroeconomic challenges of unit pricing, compression and cost inflation in combination with depressed valuations and capital availability have translated into the larger MSOs focusing more on efficiency of existing operations and generating positive free cash flow versus growth through M&A, that certainly appear to be the case in Q1 of this year, where we saw a little over $815 million in M&A transactions versus over $2.5 billion from Q1 of last year.

State programs. Shifting to state-specific programs, as noted in prior calls, we continue to see momentum in states that span the political spectrum. Missouri officially launched its adult-use program in February with regulated cannabis sales in March totaling over $126 million alone. Maryland’s adult-use program is also expected to see first legal sales in July 1st, and just last month, Delaware became the 22nd state to legalize adult-use cannabis. Meanwhile, adult-use legislation is progressing through the Minnesota Legislature and there are expectations that Ohio and Pennsylvania could legalize adult-use cannabis this year. Federal legislation. On the federal legislation front, as you know versions of the SAFE Act were introduced again in both the House and Senate late last month.

There are some reasons to be optimistic on potential passage. One this bicameral push on its face appears to signal that this legislation could be a priority. Two, a version of SAFE has passed the House seven times now and three, the Senate Bill has 40 total sponsors, including seven Republicans. That said, as we have stated for years now, getting a version of this bill through the process and into law continues to be daunting and will require significant time spent by Congress and an alignment of numerous sets of competing interests. We also want to note some of the recent commentary by federal officials and commercial organizations, which we believe show the continued momentum forward for change. In late March, the Wine and Spirits Wholesalers of America issued a letter to Congress calling for cannabis to be regulated on the federal level like alcohol advocating for comprehensive federal legalization.

Also in March, U.S. Health and Human Services Secretary, Xavier Becerra provided an update on his agency’s role and status of the ongoing cannabis scheduling review and while not providing a definitive timeline for completion of the review, did note the process will take into account shifts and what cannabis means to Americans over the last several decades. Also last month in testimony to the Senate, Attorney General Merrick Garland provided an update on the DOJ’s potential establishment of a Cole memo 2.0. While the timing and scope of federal reform continues to be uncertain, we see the reintroduction of the SAFE Act in both the House and Senate and these positions has incrementally positive steps in the road to reform. I’d like to now turn the call over to Ben to discuss our investment and portfolio activity in the first quarter and year-to-date.

Ben?

Ben Regin: Thanks, Paul. As Alan noted, year-to-date we have closed on approximately $91 million of additional investments, including follow on transactions to fund additional infrastructure at our existing properties, as well as new acquisitions. In March, we closed on the acquisition of an under development, 157,000 square feet, two story industrial building and executed a long-term lease with a new tenant, Battle Green. Battle Green’s leadership team includes Joe Caltabiano, Co-Founder and Former President of Cresco Labs, Chad Wise, Co-Founder of North American Dental Group, David Ellis, Former Chief Operating Officer of Cresco and Deanna Mettler, Former CFO of Equifax Canada. We acquired the development property in mid-construction and our total investment is expected to be $42 million.

Ohio’s medical cannabis program is well over $300,000 registered patients and Ohio is expected to decide on adult use cannabis program adoption this year. As we noted on our last call, investment activity for 2023 also includes the sale leaseback transaction for a 58,000 square foot fully operational cannabis facility with TILT in Pennsylvania for $15 million and an additional $34 million for improvements at three projects, each of which resulted in a corresponding adjustment to base rent that started immediately. Those included $15 million in additional funding for Ascend at its New Jersey facility, an additional $15 million for PharmaCann at its New York property. And an additional $4 million to Goodness Growth at its New York property. We also negotiated cross-default provisions on all leases for each of those three tenants as well as for TILT.

We also closed on the sale of a property portfolio that we previously leased to Vertical in Southern California for a little over $16 million and executed a secured seller note for approximately that amount with the buyer, with cash interest payable monthly. As you may recall, we announced the signing of that sale agreement in our last call and closed on the transaction shortly thereafter. Regarding our San Bernardino property, the property we took back from Kings Garden late last year. We executed an LOI with the group to explore a potential mixed use development of the property, which may include a self-storage component. While we are in the very early stages of this project and expect the process to take many months, we’ll look to keep you updated on our progress.

For our properties in Texas and Pennsylvania were Parallel defaulted. As Paul noted we took back the Texas property in mid-March and are currently exploring options for that site. In Pennsylvania, Parallel continues to occupy that property, while we work through the process to regain possession in the context of Pennsylvania’s licensing dynamics and we’ll provide updates as we can. With that I’ll turn it over to Catherine. Catherine?

Catherine Hastings: Thanks, Ben. For this call, I will describe our property portfolio and tenant roster. In addition to our rent collections statistics and updates on our development projects. As of March 31st, we owned 108 properties across 19 states comprising 8.9 million rentable square feet. Of these 108 properties, 103 properties are included in our operating portfolio. Our portfolio continues to be well diversified with no one tenant representing more than 14% of our total invested capital and no state representing more than 17% of our total invested capital. We have relationships with some of the largest and most experienced operators in the industry, with our operating portfolio comprised of 89% multistate operators and 58% leased to public company tenants.

In addition for operators with multiple leases with us, we have cross-default provisions included for 42% of our operating portfolio with another 14% of our operating portfolio leased to operators with just one lease with us. The total amount of capital invested and committed across our operating portfolio equates to $275 per square foot, which we believe remains significantly below replacement cost. For the first quarter, we collected approximately 98% of contractually due base rent and property management fees from our operating portfolio. The 2%, we did not collect related to contractual rent in excess of security deposits applied for our previously disclosed defaulted tenants, Parallel and Green Peak. And contractual rent not collected prior to the sale of the Vertical portfolio that Ben previously discussed.

Our revenue and rent collection for the quarter included the application of approximately $4.2 million in security deposits. As we previously disclosed in last quarter, we amended our leases with Holistic in exchange for the inclusion of cross-default provisions and extensions of terms for all the leases and agreed to apply security deposits for their rent payments to the Michigan and California properties through September 30th, with pro rata payback of these security deposits starting in January 2024. For Q1 2023, we applied $1.1 million of security deposits for these two Holistic properties, which represent less than 2% of our total invested capital and we note that rent was paid in full by Holistic at all other properties. This quarter we also applied in full the security deposits we held for Parallel, Texas and Pennsylvania and for Green Peak at our Summit property in Michigan and recorded revenue totaling $3.1 million related to these previously disclosed defaults.

We collected April and May rent from all tenants, other than Parallel for the Pennsylvania property, which Parallel continues to occupy and the two small retail properties leased to Green Peak that Paul mentioned previously. We also continue to fund draws for improvement allowances or construction development to our operators under our leases. As we’ve previously noted on prior calls, these improvements are critical for the efficient production of quality cannabis products at scale. In Q1 of 2023, we funded $66 million for building improvements and construction activity at our properties. As in prior quarters, we continue to see construction delays related to delivery of electrical infrastructure, specifically switchgears, which is the common delay seen across the entire construction industry.

We continue to believe in the tremendous value of our mission critical real estate portfolio as well as our operators and their ability to weather the current conditions. And we’ll continue to monitor their progress closely in the coming months. And with that, I’ll turn it over to David. David?

David Smith: Thank you, Catherine. I’m pleased to be here for my first earnings call with the IIP team and appreciate everyone joining for today’s call. I continue to be enthusiastic about the significant long-term growth of the cannabis industry and believe that IIP as the only publicly traded cannabis REIT on the New York Stock Exchange is best positioned to continue to capitalize on this unique opportunity by providing growth capital to the industry. Moving on to the quarter, we generated total revenues of $76 million, an 18% increase from $65 million generated in Q1 of last year. The increase was driven primarily by the acquisition and leasing of new properties, additional funding of building improvements provided to tenants at certain properties that resulted in base rent increases and contractual rental escalations at certain properties.

As Catherine noted previously, the $76 million of revenue for the first quarter included $4.2 million of security deposits applied for payment of rents with $1.1 million or $0.04 per share of that amount related to our Holistic leases in Michigan and California. And the remaining $3.1 million or $0.11 per share of security deposits fully applied related to lease defaults by Green Peak at one property in Michigan and Parallel at one property in each of Pennsylvania and Texas. For the three months ended March 31st, 2023, we recorded net income attributable to common stockholders of $41 million or $1.43 per share. AFFO for the first quarter was $63.4 million or $2.25 per share, an increase of 10% compared to the $2.04 per share of AFFO generated in the first quarter of 2022.

In addition to adding back non-cash stock-based compensation and non-cash interest expense related to our unsecured senior notes, AFFO for this quarter also adds back the non-refundable cash interest payments we received on the seller financing provided to the buyer of our vertical portfolio. As those cash interest payments were not recognized as income for GAAP purposes. We included this add back to give greater clarity on the cash flows of the company and we’ll continue to recognize this interest income for AFFO as it has received going forward. On April 14th, we paid a quarterly dividend of $1.80 per share to common stockholders of record as of March 31st, equivalent to an annualized dividend of $7.20 per common share. We have continued to share our growing cash flows with our investors as our dividends paid in the last year grew 16% over the prior year.

Our dividend remain covered by our AFFO during the quarter was a payout ratio of 80% which is in line with the Board’s targeted payout ratio of 75% to 85% of AFFO. At quarter-end, we had approximately 2.6 billion in total gross assets and roughly 304 million in debt consisting solely of unsecured debt with no maturities this year or next year and 300 million of that debt not maturing until May 2026. At quarter-end, our credit metrics remained among the best in the entire publicly traded REIT industry but that debt to gross assets ratio of less than 12% and a debt service coverage ratio in excess of 16 times. In addition, the company continues to generate significant cash flow from operations, which totaled nearly $240 million over the last 12 months.

These excellent credit metrics and free cash flow generation have resulted in us continuing to maintain our investment grade credit rating. With that I will turn it back to Alan. Alan?

Alan Gold: Thanks, David. And I would like to note the following in closing. First and foremost, our conviction is as strong as ever in the long-term growth and promise of the regulated cannabis industry. And our team of highly experienced talented professionals will continue to work through the inevitable challenges of this rapidly evolving high growth industry. With the quality of our team and strength of our balance sheet and the quality of our facilities, I believe we are well positioned to meet these challenges and continue to focus on value creation for you all, our valued long-term owners. With that I’d like to open it up for questions. Operator, could you please open the call up for questions?

Q&A Session

Operator: Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Tom Catherwood from BTIG. Tom, please go ahead.

Operator: And our next question comes from Scott Fortune from ROTH Capital. Scott, please go ahead.

Operator: Our next question comes from Alexander Goldfarb from Piper Sandler. Alexander, please go ahead.

Operator: We have a question from Eric Des Lauriers from Craig-Hallum Capital. Eric, please go ahead.

Operator: And this concludes our question-and-answer session. I would like to turn the conference back over to Alan Gold, Executive Chairman for some final remarks.

Alan Gold: Thank you. And once again, thank you all for joining us on this call today. Thank, a big thank you to the team for all their hard and dedicated work to get us to where we are today. We look forward to better things and thank you for joining us on the call.

Operator: The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.