The only 2 cannabis companies you need to own

The 2 largest hurdles for cannabis companies, deflation and legalization, are not soon to end, but there are good ways to gain exposure to this opportunity and they are trading at rock-bottom prices. Innovative Industrial Properties (NYSE: IIPR) and NewLake Capital Partners (OTCMKTS: NLCP). Both are triple-net REITs focused on financial services for the cannabis industry, producing profits even while mainstream operators struggle.

Triple-net lease REITs are attractive vehicles for income investors because of the higher-than-average yields they tend to pay. By making their customers shoulder the cost of maintenance, taxes, and utilities, they free up their cash flow for reinvestment and dividends, and both pay ample distributions. Between them, they average more than 10%, come with a positive outlook for distribution growth, and trade at a discount to their portfolio value. 

The benefits of sale-leasebacks for cannabis businesses are enormous in that they provide a means of liquidating assets and balance sheet improvement while locking in the long-term lease. For Innovative Industrial Properties and NewLake Capital Partners, sale-leasebacks provide highly visible cash flow, predictable margins, and dividends to help offset market risk. Cannabis will likely receive federal support; the only question is when. 

Normalization in cannabis markets 

The risk for Innovative Industrial Properties and NewLake Capital lies in the underlying market, which is struggling. The industrialization and legalization of cannabis is a naturally deflationary event due to the ease of growing large quantities of high-quality products. All it takes is a team of interested botanists and the capital to build a facility, of which there were ample quantities when this market was opened. The takeaway for today is that signs of constraint and normalization are at hand, and nationwide legalization remains a catalyst. 

Among the signs of normalization is a reduction in capacity. Manufacturers scaled back growth plans in 2022 and continued reducing capacity and constraining supply in 2023. This has the average price of wholesale flowers rising on a YOY basis, if only a slight 4% in August, but still down 15% compared to 2021. 

Additional signs are the efforts to control costs. Manufacturers from the East Coast to the West have laid off workers to right-size their operations and reach profitability. California alone reported a 30% YOY decrease in operators, significantly reducing capacity and availability; both will aid industry pricing and margin over time. 

Many cannabis companies are on the brink of producing sustained profits, but that may not come until federal legalization. Even with localized and state assistance, NORML estimates US legal cannabis companies paid nearly $2 billion in taxes that comparable businesses in federally legal industries didn’t. That burden will disappear when cannabis is rescheduled or legalized by Congress. 

Innovative Industrial Properties is the market leader

Innovative Industrial Properties is the 1st publicly-traded cannabis investment company to come to market and has more than $2.4 billion in assets. The company owns 108 properties in 19 states, with 1 under development. It targets well-capitalized businesses already receiving state licensing, providing long-term absolute sale-leaseback agreements. Absolute lease agreements are the strictest form of commercial real estate contract and require tenants to shoulder all expenses, including major building repairs. 

Innovative Industrial Properties has grown consistently each quarter since inception, but growth is slowing. The analysts expect sequentially flat revenue in Q4 for a low-single-digit gain compared to last year. However, they may be underestimating strength; Q3 results outperformed on the top and bottom lines. The takeaway is that profitability will persist, the stock is trading at a significant low and overextended, and the 9.5% dividend is safe for the next few quarters at least. 

NewLake Capital Partners builds a growing portfolio

NewLake Capital Partners is a newer cannabis REIT but equally well-positioned for growth. The company has $422 million under management with 32 facilities in 12 states. It is 100% leased and operates on a triple-net basis. This stock yields nearly 12% with an equally stable outlook for revenue and earnings, supported by the latest guidance. 

The company reiterated its FY guidance, including the outlook for share repurchases. NewLake Capital Partners repurchased over 700K shares year-to-date in 2023 and has enough capital left under the current authorization to double that by EOY 2024.  Analysts rate this stock at Hold and see it advancing about 50% at the midpoint.