Innovative Industrial Properties: Leverage (for a REIT) is everything

0:09Julian Lin:Julian Lin of Best of Breed Growth Stocks, the investing group he runs on Seeking Alpha, a friend of the podcast for many years. Julian, welcome back to the show. Great to have you. Great to be here, Reno. It's great to talk to you. So here we are at the beginning of 2026, a whole new year. What are you thinking about when you're looking at the markets these days? So for much of the last few years, having focused a lot on tech stocks, largely because after 2022, there was a big crash in tech stocks, creating a big buying opportunity. But of course, you know, with the big AI bubble that reduced a lot of those opportunities, although I do still think software is quite interesting.

0:50But the focus of today's podcast is actually in a totally different sector in cannabis. We've done a lot of podcasts about cannabis stocks in the past. There's finally the big regulatory development that a lot of cannabis investors have been waiting for a long time. That is namely rescheduling. I think you've done a previous podcast with Jerry and the Bengal team regarding rescheduling. Today, I hope to focus instead on a different perspective on rescheduling from the landlord perspective, which I think a lot of cannabis investors and also especially REIT investors have been ignoring.

1:23Julian Lin:So talk to us specifically why you think the re-space is worth looking at these days. And would you say especially given the rescheduling conversation or that just helps? It's like more as an aside. Yes, definitely. I think I could first point out this very interesting phenomenon, especially if the listener is coming from like a cannabis investing background. I know a lot of cannabis investors, they view the MSOS stocks as being underfollowed largely because institutional capital has not been able to easily purchase into the names prior, you know, because of regulatory restrictions. But I view a name like, and the names that I'm mainly focused on today is IAPR, that's Innovative Industrial Properties, as suffering even more, kind of ironically, even more of an issue here.

2:15So technically, IAPR, it's listed on the major exchanges. So there's no necessarily big issues why institutional capital can't buy in. However, it falls itself in the worst of both worlds, where cannabis investors, they just kind of want to focus on the operators directly selling cannabis. So they don't want to focus on the cannabis REITs. Whereas the REIT investors, they see this big 16 % or 15 % double-digit dividend yield. They see it's cannabis, and the REIT investors try to avoid it. So you get this situation where it's like, who is going to be focusing and looking at this cannabis REIT, except people who are willing to look a little deeper.

2:54Julian Lin:So when you're looking a little deeper, what are the first things that strike you as positive? Today, I would be looking at both the common and the preferred stock, but kind of focusing first on the common stock. I would first note that the valuation of IPR relative to the MSOs, which are its tenants, it's quite intriguing because as longtime cannabis investors know, the whole sector has been suffering a lot of headwinds, largely due to pricing headwinds. As price compression, prices keep coming down due to competition from legal operators and especially the illicit market. Besides this, the whole sector, of course, has been suffering from having to pay larger income taxes.

3:37So as I mentioned earlier, President Trump gave an executive order to expedite the rescheduling cannabis. This executive order is significant largely because it increases confidence that rescheduling will finally happen. And technically, rescheduling occurred back in 2024 under the Biden administration. But over the past year after the change in administration, I think a lot of cannabis investors have felt that perhaps the President Trump administration may not be as friendly to this rescheduling. So they kind of probably just forgot about it and wrote it off as no longer a done deal. But this executive order completely changes that and greatly increases the confidence that this will occur.

4:21So, yes, the rescheduling would mean that the MSOS, which are the multi-state operators, again, these are the tenants of IAPR, the landlord, which we're focusing on today. It means that they will no longer have to pay so-called 280E taxes. And 280E taxes mean that these operators pay taxes based on gross profits. So they can't deduct operating expenses or interest expenses from the calculation of taxable income. And that means a lot of these operators are paying income tax rates of like 80 % or even when they have negative operating income, they might be paying taxes. So rescheduling cannabis from Schedule 1 to Schedule 3, while it falls short of legalization, but it would remove 280E taxes.

5:08And basically, a lot of these names, like Truly, for example, that's ticker TCNNF or Verano or VRNO, they switch from negative GAAP operating income to positive GAAP operating income just once 2ADE is removed. So it's a very, very big, significant development. And we can see a lot of volatility with the MSOS ETF. But surprising to me is that investors are not focusing as much on IAPR, especially because IAPR, it actually trades at, in my opinion, a cheaper valuation than a lot of these MSOS operators. Because even if we assume that 280E taxes are removed, a lot of these operators, they're still trading at 15, 25 times earnings.

5:57And this is heavily adjusted earnings. Whereas IPR is trading at a 15 % dividend yield and around 12 times earnings, or sorry, 11 times earnings and eight times FFO, which is more critical for REITs. And I view this valuation description thing as being kind of curious because IPR as the landlord, they don't face the same price compression headwinds that the operators are facing. And that is a very important distinction because when you have price compression headwinds, you would think that a lot of these stocks, they might, the MSOS, they might be limited to the upside just due to having a more cyclical kind of business model where unfortunately, they're kind of only exposed to the downward cycles where prices go down, not necessarily prices going up.

6:45It's hard to imagine prices going up at this point. So you would think that their valuations should be held back lower. Whereas the landlord, they have a very consistent, more reliable income stream because they're just collecting rents. So regardless of how prices are going, as long as their tenants are not bankrupt and are still operating, they get the same rent payment. So that cash flow stream should be a higher quality business than that of their tenants. yet somehow the stock is trading cheaper than their tenants. And that's why I think it's quite interesting.

7:21Julian Lin:What would you say about the safety of the dividend? Prior to all of this for scheduling executive order, IEPR has seen a lot of volatility in its tenant base. For example, FarmerCan, Forefront, and over the last several years, a lot of the California operators have been in default with some of their properties. and so in the most recent quarter, they generated$1.70 or so in adjusted funds from operations per share, whereas they pay a$1.90 dividend. So their dividend is not currently covered by AFFO per share, but at the same time, so we got to look at this more critically. So approximately 20 % of their tenants are not paying rent, which means who's thinking, yes.

8:07So it means the dividend's not covered, but at the same time, it also indicates a potential upside as they release those properties, which I do think they will, especially given rescheduling looks set to occur. I would think that demand for these properties increases because just the financial profile of selling cannabis improves dramatically. You don't have to pay 280 taxes anymore. You could be more profitable. IEPR might need to reduce the market rents on those vacant properties. But at this point, from that$1.70 AFL per share, it's all upside, right? besides this we got to note that IEPR has very very low debt they have around 300 million or 330 million dollars of debts that equates to around like a 1.3 times debt to EBITDA ratio for reference its own tenants a lot of them have much higher leverage ratios and but the better comparable would be other net lease real estate investment trusts like realty income or or National Realty, or those kind of net-least REITs, those tend to have leverage ratios around five times to six times.

9:16But IEPR is at 1.3 times. It's significantly under-leveraged. I would say relative to a pure like-need-like capital, you can make the argument that IEPR has been a little more aggressive in terms of expanding aggressively in California. But in terms of balance sheet, The management has arguably done a good job of remaining quite conservative in terms of making sure their leverage ratios are very low. So what that means is, sure, the current dividend, especially in the near term, there is a risk of a cut. Because it's, again, the dividend rate is$1.90 and the AFFO is$1.70 per share. But at the same time, remember, these are net利 streets.

9:59So that AFFO flows directly to the bottom line. The tenant is responsible for real estate insurance. taxes and maintenance capital expenditures. So they don't have like extra recurring, this kind of recurring capital expenditure that is like a hidden cost to it. So that that AFFO per share is all available for shareholders. So even if we assume like a dividend cut from$1.90 down to maybe like, let's say$6 per share. $6 per share would be comfortably below that. And I'm talking about annually. So it will be going down from$7.90 per share annually to$6 per share, which would be$1.50 quarterly. It would represent like, you know, a 85 % AFFO payout ratio.

10:45Even after assuming this big cut, the stock is still trading at an 11 % dividend yield. And again, I would note that this seems very unlikely just because 20 % of their properties are not reflected currently in the financial day. when they release these, it's all extra income. And following rescheduling, the tenant credit quality should improve dramatically. So it would make me wonder, why would this stock still be trading at, currently it's a 15 % yield, assuming dividend cut, you might get to an 11 % yield. Why would it still trade at a double-digit dividend yield if, one, the tenant credit quality has improved where a lot of the operators suddenly have a gap, profitable operations, very high four-wall coverage.

11:28And the landlord also itself, its leverage is very low. So there will be a huge gap between the current 11 % dividend yield. Again, this is assuming a big cut, which I think is quite unlikely. Managing has signal they don't really want to cut. They do think way in a couple quarters, they will be able to release the properties. Even assuming big cut, the stock trades at 11 % yield, realty income trades at around a 6 % yield. That gap is way too big in light of the stronger balance sheet and the big positive, totalists in terms of tenant credit quality, I would expect IPR to re-rate at least to an 8%, 9 % yield, which would suggest huge, huge upside from current levels, especially as management and the company releases those vacant properties to boost up AFFL again.

12:14Julian Lin:In terms of the 280E component that you've been discussing as it pertains to the rescheduling conversation. You mentioned that conversation I had with Jerry and Josh from Bengal Capital. And one of the things that Jerry was talking about was that 280E, even if it does go away, it's going to take some time, like perhaps a couple of years. In that interim period, let's say everything does go according to plan, except it takes much longer. What would you say to those interim years or months or however long it takes for 280E to fall by the wayside. What would you say happens if it doesn't go away so quickly?

12:52Sure. So 280, I should first, of course, point out 280 is not the only thing that would improve. You know, you also have benefits like, especially if rescheduling is officially confirmed, we would have this situation where institutional capital, especially the debt markets, they would be seeing that, oh, 280 is going away. So the credit quality of the tenants are improving, which means a lot of these tenants as they have debt maturing I would expect them to be able to refinance their debt at much better interest rates a lot of their debt is at like 10, 11, 12 % interest rates they might be able to refinance significantly lower even in this higher interest rate environment they would have they will be able to maybe perhaps save costs a lot of operational costs that they are much higher just because being in a schedule one needs a higher cost of insurance for example, it's a very huge one but in terms of 280 specifically yeah there might be some delay and I do know one thing in the podcast which perhaps I would like to clarify or kind of disagree with they mentioned a lot of the operators they're currently already not paying 280E so I think on the podcast they might have implied it doesn't really matter if 280E is removed I disagree heavily there because one thing is yeah sure a lot of these operators are not paying 280E you know like about like Truly for example but that doesn't But that just affects the cash flow component.

14:14On the income statement, they still record the 280 taxes. So you will still see a big jump from gap losses to gap positive income once 280 is removed. And more importantly, they will no longer need to be increasing their uncertain tax viabilities once 280 is removed. So there is there, even though they are saving on cash flow already, there is definitely a big boost once 280 is removed. As far as the delay, I think the easiest, the best way to put it is, again, like with the MSOS already trading and trading on quite healthy valuations, you got to wonder, yeah, if there is a situation where the removal of 280 is delayed, this would add to a point where it hurts somehow the landlord.

14:54That would, of course, imply that it hurts the tenants a lot more. Just because the landlord has less leverage, the landlord is that profitable right now. Whereas a lot of tenants may not be. So, again, that's the question, why is a lot of cannabis investors focusing on MSOS, those stocks versus the landlord, which in my eyes, every situation, the IEPR should perform a lot stronger, especially in the bearish scenarios. That said, I don't expect the removal of 280E to take too long, especially given that a lot of the reports surrounding the rescheduling executive order indicated that cannabis executives, especially like Tim Rivers of Arturley, who has put a lot of work into making this work, they were instrumental in convincing President Trump to change his mind on this executive order and true Schedule 3.

15:44I would imagine a big component of that is 280E taxes. Given that that would be the driving force behind pushing rescheduling to occur again, I wouldn't expect it to take an egregious amount of time for 280E to be removed. I would actually be looking more optimistically that there's even a chance that, a significant chance, or rather not so insignificant chance that companies like Trulieve might be able to write off those uncertain tax viabilities. given how much of an influence they've had in delivering this. Of course, no guarantee, but this is sort of kind of like icing on the cake. Like in addition to remove 280E, they might be able to remove a lot of those component liabilities from their balance sheets.

16:28Julian Lin:Does legalization or a furthering of the regulatory conversation and advancement in the regulatory conversation, would that change your thesis on MSOs? Like would that make you more positive? Outright legalization is quite complicated. And again, I don't mean to sound so bearish on MSOS. I do note that a lot of them actually do look cheap, especially when rescheduling occurs. A lot of these things are trading at like four times EBITDA, five times EBITDA. I would just note to investors to be careful because not all of the stocks are trading at that kind of a valuation. There's definitely a lot trading at big valuations.

17:05But in terms of legalization, legalization probably would only benefit one of the operators, which is the SSO Glasshouse. That would, in my opinion, that would be the only one that would see potentially some benefit. Of course, there's some caveats there. I don't want to repeat it. I recommend listeners to listen again to your previous conversation with Jerry and the team there about Glasshouse there. But in terms of the other, the actual MSOS, the actual multi-state operators, legalization would probably be bearish, actually, because it would allow, it would formally allow interstate commerce.

17:39it would probably lead to some, it would be mildly bearish because it would probably lead to a lot of price compression across the industry. But at the same time, it would probably lead to a lot more growth. So a lot of these operators probably saw a lot more products. For example, so I live in California and this is one of the states of which are very, very positive on cannabis. But I will say even here, the mood with like an average person, it's still, people still view cannabis as like 10 times more dangerous than alcohol, which is just astounding to anyone who like actually knows cannabis.

18:14And I would imagine legalization to be that kind of tipping point that makes the average person, which is most people who don't, you know, regularly use cannabis, they would probably shift a lot of their alcohol usage to cannabis just because it's legalized. There's going to be more media surrounding cannabis. It's going to be a huge event over, you know, one, two year period. Not as immediate as more of the 2A rescheduling, but I would imagine it to lead to the secular tailwinds that a lot of the industry had been hoping for. But the initial impact might be price compression. So it'll be near-term bearers for long-term bullish for MSLSs.

18:52I would view legalization.

18:54Julian Lin:I appreciate that. Out of curiosity, when you say that people are still more in favor of alcohol than cannabis, I would agree with that. But I do find that it's kind of across like generational lines, like younger people do tend to understand that cannabis is better for you than alcohol. Would you say the same thing? So I would agree, but also note that even with the younger people, a lot of younger people actually still are very, very pro-alcohol and very negative cannabis. So there's a lot of gains to be made there. But at the same time, I do think legalization is probably, well, very far away given how clearly our politicians cannot agree on anything.

19:35And legalization would need very, very universal cooperation to occur. But yeah, even now, surprisingly with the young people, they still think alcohol is safer. And I don't blame them, right? I mean, cannabis right now, you've got your parents telling you, oh, it's very risky. Whereas alcohol, you could buy at a safe way, right? So there's a huge difference. And alcohol is like a cultural. It's like you're sophisticated if you know what kind of liquor you're drinking, right? You're like, you're a better, you're more, you're better in society if you know how, if you have a liquor you like. Whereas with cannabis, you're just a drug user if you use it at all.

20:11So that stigma is huge. It's very, very different. And I would imagine to have a big impact. And I would imagine legalization to be the only thing at this point. I mean, at this point, you see even media influencers is trying to even you see LeBron James or some NBA players saying they like cannabis for recovery. That hasn't made the impact you would have expected. So I think legalization is going to be that that is the turning point that is necessary, you know, to drive more, the more of the volumes and price stability that a lot of these MSOs are hoping for.

20:42Julian Lin:Yeah, it's definitely a slow roll. I mean, speaking of legalization, we don't even know when this executive order or if this executive order will come to pass. I mean, there's a lot of promises in the headlines that are not quite at that promise level yet. A lot to parse between fact and fiction in this sector and across sectors, but in this one for sure. Julian, when it comes to REITs, what would you say are the one to two to three biggest risks that you see for REITs in general, for cannabis REITs, and then for IIPR specifically? Yes, good question. And yeah, as I mentioned, I spent a lot of my recent years looking at software starts, but mostly that was just mostly because of valuations.

21:24Prior to that, I had been looking a lot into REITs, largely because Amazon had been becoming bigger, you know, like six years ago, and that made me more interested in a lot of the shopping center and mall REITs at that point. Yeah, so with REITs, I would say the single most important and very highly underestimated financial metric, you know, that investors should be looking at is leverage. And again, I'm not trying to top my own horn so much with IAPR, but having a ton of leverage versus having low leverage is everything for a REIT. For example, typically, when you think about these REITs that go down and go bankrupt, have to eliminate the dividend, they never come back.

22:06I would say most of the time or 90 % of those times, it's all because of the leverage. You could have underperforming operations, you could be in decline. and a lot of the reinvestors might be familiar with some names that they might trade to like three times FFO, four times FFO, really, really low valuations. But somehow that margin of safety, quote unquote, doesn't apply because all of a sudden they go bankrupt, there's no dividend. And you're like, how did this happen when I was buying it at like 30 % FFO yield? It all comes down to leverage. Because when you have a high amount of debt, then what that means is that as earnings decline, what matters most is no longer that FFL multiple because a lot of that earnings is no longer available for shareholders.

22:54A lot of those earnings have to be put down to paying down debt. The reason why is that tend to have things like covenants, first of all, which means that if you breach certain things like debt to equity or debt to assets, like in terms of how much leverage you have, if the amount of debt goes too high, the debt holders are allowed to declare the equity in default and basically take over the entire company, right? And besides this, these companies, they also have to refinance the debt. So when the debt matures, they want to be able to issue new debt to replace that debt. But if they don't want to issue the new debt, like a 15 % yield, they have to, again, maintain a lower leverage ratio.

23:36So when earnings go down, that would mean the leverage ratio, which again, it would be debt to EBITDA, it would go up. So if your leverage ratio to begin with is too high and then your earnings start to go down, you get into this negative feedback loop where you have to spend more and more of your cash flow away from dividends and towards paying down debt, which may or may not be enough to stop the cycle. Let's look at IPR. In this case, the leverage, again, it's at 1.3 times that the EBITDA. It's ridiculously lower compared to the around six times that the EBITDA typically that these freets trade at.

24:12or operate at. What that means is that even right now, like the most recent quarter, you know, AFFO dropped like 25%. It dropped a lot. It doesn't matter. They're not worried at all because their leverage is so low that it doesn't impact the financial stability whatsoever. So when you look at the stock trading so cheaply on an AFFO basis, that's real. You're not worried about some of that cash flow being needed to go down to pay down debt. There's no need to pay down debt. They could if they wanted to, but there's absolutely no need. And that brings me, I think I should mention the preferred stock, actually.

24:45While I do think there's a lot of upside in the common stock, especially because it yields 15%. And I think it will rebate to the 9 % level, which would be a stock price around$84 or so. I think the preferred stock, and that's the ticker IAPR.PR.A, it depends on the brokerage, but it's the A-class preferred stock. I think this will appeal to a lot of investors, or perhaps appeal to more investors, just because it's far less risky. Even though it's the same company, the preferred stock tends to have a far lower risk profile, largely because one, the preferred stock dividend has to be paid before the common stock dividend.

25:22So IPR, they could cut the common dividend, but the preferred stock dividend will still be paid in full. And two, it's cumulative, these dividends, which mean that if they pause a preferred dividend, it accumulates. So it means that prior to ever resuming the common dividend, they would have to pay all the missed preferred dividends in full. But the key thing here is, again, I already know that I'm with the view that the common stock is not nearly as risky as implied by the current valuation. But perhaps an investor will think, okay, but the dividend cut is still coming. And whenever a cut is still coming, you never feel like the cut is always priced in.

26:01You never know how much the cut will happen. and they might feel like the common stock still has some risk. But the preferred stock, it's very different. And I recently wrote a public report on Seeking Alpha, which also in depth covered that preferred stock. So the preferred stock is covered by earnings, like AFFO, by 48 times. And just for reference, when you compare this preferred stock, which is currently yielding around 9.5%, when you compare it to other high-yielding preferreds, like in the 7 % to the 9 % range, so like even lower-yielding than this one, the coverage from AFFO tends to be more in the, it tends to be more in like the four times to eight times range.

26:46At the highest, it will be eight times. But remember, with this IPR preferred stock, it is at 48, 48 times. It's exponentially higher in terms of coverage. And what that means in this case is like, So I ran a risk analysis, even if IPR was forced to cut all of their rents by 50%. So that means, remember, they already are not getting paid 20 % of the rest. If we assume zero recovery there, and on the remaining tenants, which are currently paying rent, they cut rents by 50%. In that situation, the preferred stock dividend will still be covered by 16 times, which would, again, this will be a huge, it will still be the safest preferred stock by far, compared to any of the other high-yielding preferred stocks, the leverage would rise to 3.7 times that tip, which will still be safer than realty income in terms of leverage.

27:37So even in this worst-case situation, which has become very, very unlikely due to rescheduling, the preferred stock, it's still very, very safe. And it's still yielding 9.5%. The potential upside is, of course, capped by the possibility of being called at$25 per share. But even then, I would still expect a stock, I still expect the preferred stock to trade up to around$26,$27 for sure, a bit higher than the call value, just because it's unlikely that the company will call the preferred stock as long as a common stock is yielding so much. So in my eyes, it looks like it's yielding 9.5 % with around 6 % to 7 % capital appreciation upside to$25 and more like 10%, 15%, or sorry, more like 10 % to 15 % of potential upside to around, you know, $26,$27 for sure in additional capital appreciation.