Innovative Industrial Properties, Inc. (NYSE:IIPR) Q3 2023 Earnings Call Transcript

Innovative Industrial Properties, Inc. (NYSE:IIPR) Q3 2023 Earnings Call Transcript November 2, 2023

Operator: Good day. And welcome to the Innovative Industrial Properties Incorporated Third Quarter 2023 Earnings 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 will now hand the call over to Alan. Alan?

Alan Gold: Thank you, Brian, and welcome, everyone. We are pleased to report our financial results for the quarter, which I believe reflect our team’s continued dedication and hard work in the execution of our day-to-day operations. As I have noted in the past calls, we are pleased with our company’s position as the broader macro economy and the regulated cannabis industry continued to experience challenges that have impacted operator fundamentals in a number of respects. We have one of the strongest and most experienced teams of real estate professionals in the cannabis industry, a high quality portfolio and arguably a conservative and flexible balance sheet, with a 12% debt to total gross assets, no variable rate debt, no meaningful debt maturities until May 2026.

And as noted in our earnings press release issued yesterday, we have further enhanced our liquidity position by obtaining a revolving credit facility, which David will touch on in his prepared remarks. To recap the quarter, we generated total revenues of $78 million in Q3 and adjusted funds from operations of $65 million. Rent collection for IIP’s operating portfolio was 97% for the quarter. The financial performance continued to drive dividend returns to our investors with $7.20 of dividends declared per share in the past 12 months, an increase of 6% over the prior 12-month period. The Q3 dividend payout ratio was at 79% of AFFO, modestly below the midpoint of our targeted ratio of 75% to 85% of AFFO. This quarter was another quiet one for us in terms of additional acquisitions and investment activity.

As we noted for several quarters, we expected a significantly slower pace of investment activity given the ongoing macroeconomic uncertainty and significant adjustments to cost of capital since the Fed began aggressively raising rates last year. We did commit additional funding to complete the development of one of our New York properties, which Ben will discuss. From a regulatory perspective, we are certainly following closely the development stemming from the Department of Health and Human Services recommendation to the DEA that cannabis be rescheduled from Schedule I to Schedule III under the CSA. Of course, there are significant benefits to this, including a potential lifting of the confiscatory 280E federal taxes imposed on regulated cannabis operators and Paul will discuss our thoughts in more detail.

While the vast majority of our tenant base continues to perform, we have previously discussed, we have taken back certain properties from Parallel, Green Peak and Kings Garden, and Ben and Paul, will provide updates on those properties. As always, we are here to answer any questions you have to the extent we can. I will now turn the call over to Paul to discuss regulatory and industry dynamics. Paul?

Paul Smithers: Thanks, Alan. Before discussing overall market developments, I’d like to provide an update on the properties leased or previously leased to Parallel, Green Peak and Kings Garden. 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 the inevitable ups and downs of this industry. We have engaged local counsel and other advisers in these situations, commenced legal proceedings for damages and possession and are in discussions with applicable regulatory agencies. As we noted in our call last quarter, Green Peak was placed into receivership in March and in mid-March, we regained possession of the Summit building, a cultivation and processing facility under redevelopment.

In addition, in May, 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 and expect to regain possession of one more retail location at the end of November. The receiver is paying rent on all other remaining properties leased to Green Peak, including the harvest part cultivation and processing facility and the remaining retail locations. The court approved the sale of Green Peak’s assets to a buyer in October with the buyer assuming the harvest peak lease and leases for the remaining three retail locations with no changes to terms. As noted on our prior calls, we also filed actions against Parallel for possession and damages at our Pennsylvania property and our Texas property.

We regained possession of the Texas property in March, which is in the early stages of development and the Pennsylvania property just earlier this week. We are actively exploring all options for these properties. As we noted previously, Parallel continues to be current on their obligations for the other two properties we leased to them in Florida. And in late September, as we previously disclosed, we regained possession of the remaining four properties previously occupied by Kings Garden and Ben will discuss our marketing activity on those properties, as well as for the Summit building in Michigan. Market developments, as we have noted for some time now, the regulated cannabis industry continues to experience a set of challenging circumstances.

But I would like to note that even during this macroeconomic environment, growth of the overall cannabis industry in the U.S. continues to remain strong, with BDSA projecting cannabis sales of $29.5 billion in 2023, representing approximately a 12% growth from 2022. Additionally, BDSA estimates that approximately 60% of U.S. adults could have access to adult-use cannabis by 2026 with new state programs coming online. Unit pricing for regulated cannabis products has been under pressure 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 law enforcement authorities, taxation and general macroeconomic conditions.

That dynamic continued through Q3 as a general matter, though, of course, with some state-specific variations and we have seen an uptick in national spot wholesale pricing since mid-September. Capital availability, another continuing theme from our prior calls is the impact that the tightening of financial conditions has had 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 plus. With Viridian Capital Advisors reporting that both U.S. operator capital raising and mergers and acquisitions activity year-to-date were at their lowest levels since before 2018, the funding environment continues to be significantly challenged right now.

Federal legislation, on the federal legislation front, there were a few noteworthy developments. In late September, the SAFER Act was passed by the Senate Banking Committee, marking the first time that cannabis banking legislation advanced through this committee. While a symbolic victory, SAFER was also supported by a bipartisan coalition of 22 state attorneys’ general in a letter sent to congressional leaders and with Senate Majority Leader, Chuck Schumer, bowing to bring the act to the floor, quote, as quickly as possible, unquote. There remain numerous obstacles in getting the act to Congress and into law. So we are tempered in our enthusiasm as we have been with prior SAFE Act introductions starting 10 years ago. Of course, the other significant development during the quarter was that in August, the Department of Health and Human Services recommended to the DEA that cannabis be reclassified from a Schedule I drug to a Schedule III drug under the Controlled Substances Act.

HHS based this recommendation on an FDA review of cannabis’ classification pursuant to President Biden’s Executive Order in October of 2022. The process for reclassification will require DEA approval and likely complex administrative rule-making proceedings and it remains unclear how long this process will take and the scope of any final decisions on rules. That said, such a reclassification is expected to end the 280E tax treatment, which has imposed an extreme tax burden on regulated operators, which would be a great win for the industry and immediately provide for a significant improvement in many operator financials. We will, of course, be monitoring progress in this area closely in coming months. I’d like to now turn the call over to Ben to discuss our portfolio and leasing activity in the third quarter.

Ben?

Ben Regin: Thanks, Paul. As we noted earlier, we have regained possession of certain assets from Parallel, Green Peak and Kings Garden, and are continuing to focus on re-leasing efforts on those properties. Regarding our Summit property in Michigan, which we took back earlier this year, we executed an LOI to lease the entire property and are working through lease negotiations and final planning for completion of the redevelopment of that project. With respect to the four properties previously occupied by Kings Garden until late September, we are pleased to announce we executed an LOI for lease for the 19th Avenue and McLane properties earlier this week, just over a month after regaining control of those two assets. We are also in active discussions regarding the other two smaller properties and evaluating alternative uses, including non-cannabis uses given certain zoning changes that have impacted those properties.

Those two smaller properties represent less than 1% of our total invested capital. Regarding our San Bernardino property, which we took back from Kings Garden late last year, we continue to explore a potential mixed-use development of that property, which may include a self-storage component pursuant to an LOI executed with a potential joint venture partner. As we previously noted, we expect the process to take many months, but we will continue to report on progress as we can. For our properties in Texas and Pennsylvania where Parallel defaulted, we took back the Texas property in mid-March and continue to explore options for that site. In Pennsylvania, Parallel wound down its operations in late October and we were awarded a judgment for possession and damages at trial in late October.

While we have been active on the leasing front, in terms of new investments, it was a relatively quiet quarter. As we have noted for several quarters now, given the significant adjustments to cost of capital across industries, including our own cost of capital and the macroeconomic uncertainties the regulated cannabis industry has been facing, we made a strategic decision to reduce our overall investment activity and continue to be extremely selective and patient in evaluating potential investment opportunities. As Alan noted, in late October, we amended our lease with Goodness Growth in New York, providing additional funding to complete the development of the expanded cultivation and processing facility and adjusting rent accordingly. As Goodness Growth disclosed last quarter, the company is exploring the sale of its New York operations, including the operations at this facility.

With that, I will 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 collection statistics and updates on our development projects. As of September 30th, we owned 108 properties across 19 states and leased to 29 operators, 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 16% of our annualized base rent and no state representing more than 15% of our annualized base rent. We have relationships with some of the largest and most experienced operators in the industry with our leased operating portfolio comprised of 90% multistate operators and 62% leased to public company tenants.

The total amount of capital invested and committed across our operating portfolio equates to $274 per square foot, which we believe remains significantly below replacement cost. For the third quarter, we collected approximately 97% of contractually due base rent and property management fees from our operating portfolio. The 3% we did not collect related primarily to our previously disclosed defaulted tenant Parallel at one of our Pennsylvania properties. Our revenue and rent collection for the quarter included the application of approximately $2.2 million in security deposits. As we previously disclosed, we amended our leases with Holistic in exchange for inclusion of cross-default provisions and extension of terms for all the leases and agreed to apply security deposits for rent payments to the Michigan and California properties through September 30th, with pro rata payback of these security deposits starting in January 2024.

Holistic began paying rent on these properties in October. Similarly, as disclosed last quarter, we amended our lease with Temescal in Massachusetts, a property that experienced delays in completion of construction, pursuant to which we extended the term of the lease, temporarily reduced base rent for April through January and then increased the base rent for the remainder of the term, with application of security deposits for certain rent payments. Temescal began paying rent in September, which has been fully collected through October. Finally, as we disclosed last quarter, we amended our lease with 4Front at one of our Illinois properties in July, applying a portion of the security deposit to pay one-half of the monthly contractual rent due from the tenant, commencing on October 1, 2023, and continuing through November 30, 2023, with repayment over a 12-month period starting in January.

4Front has paid the 50% of rent due since this amendment. Similar to our third quarter stats, in October we collected approximately 97% of contractually due base rent and property management fees from our operating portfolio with the 3% we did not collect relating to our previously disclosed defaulted tenant Parallel in Pennsylvania. We also continued to fund draws for improvement allowances or construction development to our operators under our leases. As we have previously noted on prior calls, these improvements are critical for the efficient production of quality cannabis products at scale. In Q3 of 2023, we funded $18 million, net of building improvements in construction activities at our properties. And with that, I will turn it over to David.

David?

David Smith: Thank you, Catherine. For the third quarter, we generated total revenues of $78 million, a 10% increase from Q3 of last year. The increase was driven primarily by an increase in tenant reimbursements versus the prior period, as well as activity in prior periods for 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, the $78 million of revenue for the third quarter included $2.2 million of security deposits applied for payment of rents or $0.08 per share. For the three months ended September 30, 2023, we recorded net income attributable to common stockholders of $41 million or $1.45 per share.

Adjusted funds from operations for the third quarter was $65 million or $2.29 per share, an increase of 7.5% compared to the $2.13 per share of AFFO generated in the third quarter of 2022, driven by increased tenant reimbursements, revenue generated by properties acquired in prior periods, contractual rent escalations and revenue earned on additional CapEx investments at existing properties. AFFO for the third quarter was up $0.03 per share versus the second quarter AFFO of $2.26, with the increase primarily due to contractual rent increases, slightly offset by lower income from the Kings Garden portfolio. Notably, regarding Kings Garden, results in the third quarter included $1.7 million or $0.06 per share of rent from them. And as Paul noted in his remarks, they are no longer a tenant as of the end of September.

On October 13, we paid a quarterly dividend of $1.80 per share to common stockholders of record as of September 29th, equivalent to an annualized dividend of $7.20 per common share. As Alan noted, our dividend remained covered by our AFFO during the quarter with a payout ratio of 79%, which is in line with our Board’s targeted payout ratio of 75% to 85% of AFFO. Turning to the balance sheet. At quarter end, we had approximately $2.6 billion in total gross assets and roughly $304 million in debt. Importantly, all of which is at a fixed rate. Our debt consists solely of unsecured debt, with the majority of this or $300 million, not maturing until May 2026. In addition, our credit metrics remain strong and among the best in the entire publicly traded REIT industry with a debt-to-gross assets ratio of less than 12% and a debt service coverage ratio in excess of 16x.

While our balance sheet remains in excellent shape, in October, we added additional liquidity with the closing of a $30 million three-year revolving credit facility, which can be expanded subject to obtaining additional bank commitments. Pricing is based on the prime rate plus an applicable margin based on the deposits with our bank. Notably, since our IPO, we have always strived to maintain access to multiple capital markets, as we have previously accessed the common stock, preferred stock, convertible debt and unsecured bond markets. The closing on this revolving credit facility further demonstrates our ability to access capital in the cannabis industry and provides another liquidity option for the company. With that, I will turn it back to Alan.

Alan?

Alan Gold: Thanks, David. I’d like to note the following in closing. We continue to be steadfast believers in the long-term growth and success of the regulated cannabis industry and our team of dedicated professionals and advisers is singularly focused on navigating our company through this rapidly evolving business environment. We have a solid foundation of properties, a dedicated team and a clear vision for the future. We are optimistic about the legalization trends. We believe our expertise, property portfolio and balance sheet position us well for the future. Now, with that, I’d like to open it up for questions. Operator, could you please open the call up for questions?

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Q&A Session

Operator: [Operator Instructions] The first question comes from Tom Catherwood with BTIG. Please go ahead.

Tom Catherwood: Thank you, and good morning, everybody. Maybe, Paul or Alan, thinking more broadly of the cannabis industry in the U.S., you mentioned modest improvements in wholesale pricing starting in the fall, and obviously, we have seen recent states that have added adult-use programs. With that as a backdrop, how is the business outlook for your tenants trending and are there any markets where you are incrementally more constructive or hesitant at this point?

Alan Gold: Thanks, Tom. I think you are asking a really good question, and I wish I had the best crystal ball with the clearest vision. We think the industry continues to perform well. I think it continues to be very widely accepted as we have described the number of states that have — now have either adult-use or medical cannabis, I think, it’s 40 states now. And growth in sales continues to increase year-over-year with the projection that by 2027 it’s supposed to be over, I think, $43 billion in total sales. So, I mean, I think, the industry, in general, is continuing to move in a positive direction. What we are potentially experiencing is the growth rates have not been or not as robust as they have in the past, but maybe positioning themselves for future higher growth rates than we have experienced this year and expected early next year. So I think that’s the best we can do in analyzing where we think the industry is today.

Paul Smithers: And I could add, Tom. This is Paul. That — we look at the rescheduling possibility next year as just a huge positive, obviously, with the 280E implication and I don’t think we can overstate the impact 280E relief would have on operators across the board. So we look at that as a real positive. Also, we still look at state developments, Ohio next week has a boat on REC and all eyes on Ohio next week. So there’s a lot of positive things going on in the industry.

Tom Catherwood: Great. Appreciate those comments. And then maybe for Ben or for Paul, going over to the assets you have had in the market, great to hear the news on the LOIs. Maybe just a broader question on the marketing of assets when you get them back. When you have them out, is the demand mainly coming from MSOs looking to add higher quality cultivation assets or kind of, Paul, as you alluded to, with the potential for the rescheduling, are we seeing new company formation and maybe new capital coming into this industry that we hadn’t seen in the past six months to 12 months? What’s the kind of mix of those tenants out in the market looking at your assets?

Paul Smithers: Yeah. Let me ask Ben to respond to that. He is with that every day.

Ben Regin: Hey, Tom. We are really seeing a mix, which I think was great to see when we took some of these properties back and took them out to market. Our — the two properties, the two main properties from Kings Garden that we recently got back that we were pleased to announce an LOI for. We saw interest from new companies that we are looking to get into the industry. We saw interest from existing players in the California market. It was really a good mix of existing and new companies that I think really saw the value in those assets if these were fully built out. As we have said in the past, these are mission-critical facilities that take a lot of investment and time to build, and the fact that, we had fully built out ready-to-go facilities really feels very attractive to a lot of different types of companies. And I think we saw that in both the amount of interest and how quickly we were able to put those properties under LOI.

Tom Catherwood: Thanks, Ben. Really helpful. And then maybe for David, great to see the addition of the revolver in the fourth quarter. As far as the process behind adding that, was this a matter of it took a while to find the terms and the rate and the structure that worked for you and so you have pulled the trigger now or are you looking out at opportunities in the market and just the added capital flexibility gets you to where you want to be? Can you provide any kind of color on the thought process behind that?

David Smith: Yeah. Sure, Tom. The revolver itself, I’d say, more so the latter that you mentioned. It was an opportunity just to bolster liquidity at the company. As you know, we already have an incredibly strong balance sheet. It’s just a chance to add additional liquidity for the company was attractive to us. I will say in terms of the — what I can say on the bank itself, it’s a very large bank. They have been lending in cannabis for a couple of years now. They have over $60 billion of assets. So I think that also speaks to, one, just interest in the industry and also interest in us as a credit. And pricing is also very, very attractive too with no ongoing use fees. So just again, at the end of the day, it’s just another chance to increase liquidity for us.

Tom Catherwood: Thanks, David. And then just last one quickly for me. Ben, remind us, when a tenant is looking to sell their business, like you mentioned for Goodness Growth in New York, what is IIP’s involvement, do you have a say in assigning the lease to a new operator?

Ben Regin: Yeah. Hey, Tom. We would not be involved necessarily in the discussions on a transaction, but yes, of course, we do have a say over anyone that might come in to want to lease our buildings. So we do get involved from a lease assignment perspective in terms of who the new tenant would be, we will underwrite them just like we underwrite any other transaction and make sure that it’s a good fit that we feel for the property.

Tom Catherwood: Got it. Really helpful. Thanks for all the answers everybody.

Alan Gold: Thanks, Tom.

Operator: The next question comes from Scott Fortune with ROTH Capital. Please go ahead.