The malaise that has gripped financial markets this year has had countless repercussions on various sectors and industries. Very little has worked this year, but one thing that has definitely not worked is all sorts of growth-oriented stocks. We generally think of technology, consumer discretionary, etc. for growth, but in real estate there is a superstar REIT that also fits this bill.
Innovative industrial properties (NYSE: IIPR) is the fastest growing REIT I’ve seen, and the potential is huge over the longer term. However, the stock has lost two-thirds of its value during this bear market, and I think that’s overdone.
The daily chart above is obviously very ugly, as we’ve seen a never-ending bearish trend since growth fell out of favor on Wall Street. However, I happen to believe that we are not that far off from growth returning to favor, and if I am correct, the IIPR stands to benefit immensely.
On the price chart, I have annotated the most recent relative low as well as the positive divergences we have seen in the momentum. Basically, when the price makes a new low, but the momentum improves, we call it a positive divergence. Although it is not a guarantee, it often portends a change in the prevailing trend. It also works in reverse, helping to call highs on stocks that have been rallying for a very long time. We have positive divergences in place for the 14-day RSI and PPO, so this is a very good start.
The 10-day rate of change is also extremely oversold at -19%, and the IIPR outperforms its peer group. To be fair, his peer group was horriblebut I think that will change too.
Soaring interest rates are never good for real estate companies, as they tend to borrow very heavily to maximize returns. For anyone who borrows heavily, if your borrowing rate goes from say 2% to 5%, that dramatically increases the cost of borrowing without any sort of commensurate gain in your ability to generate income. That’s what we’ve seen, and that’s at least part of the reason REITs get pounded. However, the IIPR, as I will show below, should be well protected from this and continues to follow its growth trajectory.
With that in mind, and what I believe seems like the beginning of a bottoming process on the chart, the IIPR should be much higher a year from now than it is today.
The case for growth
IIPR is the first publicly traded REIT that focuses solely on the regulated cannabis industry. That means he has a first-hit advantage in space, and given how he’s developed over the past two years, he also has a scale advantage.
The IIPR focuses on buying specialized industrial properties which it then leases out to cannabis operators of various types. Cannabis operators with limited capital can take advantage of IIPR’s leaseback program to preserve that capital and invest it in their business rather than their space. It works, and I believe it has the potential to fuel years of exceptional growth for IIPR.
I’m not the only one who thinks the IIPR will grow at high rates, as analyst estimates and revisions can be seen below.
Estimates for this year have been essentially flat since last summer, while estimates for 2023 have dipped somewhat. This has no doubt contributed to IIPR’s stock price decline, as when growth companies begin to see lower revisions, the bullish glow quickly fades from the stock. Just ask any software company that has seen its stock decimated this year.
The fact is that these estimates seem very stable, and I see no fundamental reason why we should expect further downward revisions. Given the stock’s valuation – which we’ll see below – that should be more than enough.
We’re also looking at massive year-over-year revenue growth, which I’m not sure market participants realize given the stock’s performance. Revenue growth is set at 40% this year and over 20% in each of the next two years. I don’t know what more you could ask for, but it sounds good to me.
Another contributing factor is falling FFO estimates, which look less stable than the top line, to be fair.
This is not a good situation for bulls and reflects the expected decline in revenue profitability, a sign of lower margins. Although IIPR may face higher funding costs in the future, I see no reason for alarm.
I like to assess interest expense against operating income because if we know the liabilities of the business against its ability to generate profits against those liabilities, we can assess debt sustainability . To do this, I plotted operating income on a rolling twelve-month basis as well as interest expense, both in millions of dollars.
Interest charges are certainly increasing, but that’s because the IIPR is growing rapidly, and part of that is due to the issuance of debt as base capital. There’s nothing wrong with that unless it’s overused, but that’s definitely not the case here. Interest expense was only 14% of operating profit in the most recent TTM period, which is very low for any company, but extremely low for a REIT. In other words, if the IIPR has seen lower estimates and a lower valuation due to the spike in interest rates – which I believe has been the case, with the rest of the REITs – these fears are unfounded on the basis of facts.
Of course, the IIPR dilutes shareholders through the issuance of common stock, as is the case with most REITs. A recent dilution has been to swap debt for equity with noteholders, which I’m not a big fan of.
The impact is that it becomes more difficult to grow AFFO per share over time, and remember that when the IIPR issues shares, the dividend also becomes more expensive. This may mean that the actual down payment is actually higher when the shares are issued than it would be if the debt were simply rolled over to a longer term. However, this is what management has chosen, and it is something to keep in mind if you want to own this stock; you will be diluted over time, and you will not know by how much until it has already happened.
Despite this, IIPR’s pace of acquisitions continues to fuel large year-over-year revenue increases, and given the strength of the balance sheet and the highly profitable model employed by IIPR, I I have little reason to think that will change. The stock’s poor performance this year is a gift to new buyers, and I’ll detail why I think that’s the case below.
Rating screams “buy”
Let’s start the valuation discussion by looking at price/AFFO, which has been below for three years.
IIPR’s P/AFFO fell to just 11.8X on a forward-looking basis, which is very close to the COVID panic low of two years ago. Keep in mind that over the past two years, the IIPR has grown by leaps and bounds and has proven unequivocally that its model works. It still has two years of expertise and acquisitions under its belt, but is trading at around the same low multiple.
I’m not suggesting we revisit 40X FFO, but 20X? Absolutely. In a growth-oriented bull market, we might even see 25X FFO again without too much of a stretch. We are less than half today, so the fact is that the valuation risk is very much on the upside.
Since we’re looking at a REIT, price-to-book ratio is a relevant metric, and I like tangible book value because it strips out goodwill and other nonsense and gives us only real assets and liabilities.
The IIPR P/TBV is also very close to COVID panic lows at just 1.7X today. The average for this period is close to 3X, and just like P/AFFO, we could (and should) see some mean reversion. This would provide an upside scenario of around 75%, similar to the P/AFFO multiple.
Finally, one thing that I haven’t mentioned is performance, because for most of IIPR’s time as a publicly traded company, its performance has been quite poor. However, today the yield is 7.0%which is almost unbelievable.
This company has increased its dividend many times over its relatively short history, and today you can reap the benefits by owning a blue-chip growth stock and earning a mammoth yield. I don’t usually base my recommendations on dividend yield, but it’s hard to ignore it in this case.
Moreover, as a valuation tool, the dividend, like the others we have reviewed, very clearly indicates that the IIPR is undervalued. The average return is below 4%, and we are at 7% today, again in line with other valuation methods to say there is huge upside potential today.
IIPR’s business is unique, especially in a sea of equally managed REITs that have extremely similar business models. The IIPR has found a niche that allows for huge growth, with many years of track remaining. Also, the fall in growth stocks this year has made the IIPR far too cheap depending on which valuation metric you choose.
I see that P/AFFO, P/TBV and the dividend yield are all pointing to around 75% upside just from the valuation alone, whatever growth the company can produce. I think the chart is also showing the first signs of a sustainable bottom meaning we have what is likely to be very close the best value you will be able to buy IIPR for years to come.
Also, I’m aiming for a $200 run later this year, which would be ~85% higher than today’s price. Although it sounds weird today, all we need is mean reversion on the multiples we looked at. Twenty times forward earnings by the end of this year would be $200 ($9.95 X 20), and I see no reason why that isn’t achievable. This is a golden opportunity to own what I think is the best REIT this market has to offer at an extremely discounted price.