A Broader Look At The Cannabis Sector: Part 1

Many investors avoid the cannabis industry altogether for various reasons. Some people choose not to invest in the sector, and I’ll be the first to admit that the industry has seen plenty of issues since cannabis companies hit the public markets in the last decade. However, the setup is very attractive for long term investors. The companies are growing at rapid rates, especially compared to the valuations in the sector. On the industry’s unofficial holiday, I will be writing about the sector along with a summary for all the companies I own.

Investment Thesis

The cannabis industry has is a complicated industry to understand. The regulatory environment is different from state to state, with some states allowing medical or recreational use and others keeping it illegal. There are also financial regulations that create problems for the industry, but regulatory reform has been in the works for some time now. I will talk about a couple potential regulatory changes that could have a huge impact on companies in the sector. I will also summarize the REITs that I own and wrap up with what I think the sector could look like in 2030.

The Regulatory Circus In The Cannabis industry

If you are following these companies, I’m assuming that you will be at least a little bit familiar with some of the regulations and problems with the sector. While I think that our politicians will drag their feet, it’s only a matter of time before the regulatory environment changes for the better.

280E

One of the biggest problems for operators is section 280E of the tax code. If you are interested and want to read a good summary, I have included a link here. Basically, the tax code as it is currently written means that the MSOs can’t deduct many of the regular operating expenses and pay a much higher effective tax rate than other businesses. Once this gets fixed, it will be a huge boost to the bottom line for these companies and it will dramatically reduce the tax burden.

SAFE Banking

Another big problem for the industry is that transactions occur primarily in cash. This makes dispensaries a prime target for theft and creates issues for the day-to-day business operations. Once this passes, it will streamline operations and reduce theft. This would be the biggest benefit for the functioning of the business. For investors, there will probably be an added bonus. This should also allow large institutions to invest in the sector, which will probably lead to a significant rerating in the multiples of the MSOs.

While I think both 280E and SAFE Banking changes are only a matter of time, I have had a front row seat to the circus in Washington D.C. over the last two decades. I know better than to be optimistic on progress and changes on the regulatory front, but my best guess would be that we start to see changes by 2025. These changes will be very bullish for MSOs, but they could have a different impact on the REITs focused on the cannabis sector.

The REITs

Innovative Industrial Properties (IIPR) was the first cannabis REIT to hit the public markets, and it has been the best performing REIT since. There have been several newer entrants as the success has drawn competition. Power REIT (PW) has transitioned its focus to greenhouse properties and has an interesting group of assets. In 2021, we also saw newly public companies like NewLake Capital Partners (OTCQX:NLCP) and AFC Gamma (AFCG). NLCP is taking an approach similar to IIPR, while AFCG is a lender focused on the cannabis space.

Innovative Industrial Properties

I have written about IIPR several times, each time more bullish than the last as the valuation has become more attractive with the recent selloff. IIPR is the largest cannabis REIT with a market cap of $4.7B and has carved out a profitable niche. Shares trade at a price/FFO just under 25x and carry a dividend yield of 4.1%. They hiked the quarterly dividend by another 17% from $1.50 to $1.75 and I think the dividend growth is likely to continue. IIPR might not have the same upside as the smaller REITs, but I still think it will outperform the REIT index by a wide margin. For investors looking for more detail on the company, feel free to read my recent update here.

NewLake Capital Partners

NewLake Capital Partners is newer to public markets and went public in the second half of 2021. The company is much smaller, with a market cap just over $500M. Like IIPR, NLCP also focuses primarily on buying cultivation properties. Shares have had a rough start on the public markets because the company isn’t listed on one of the major exchanges. Management is working on getting uplisted, which would likely lead to a bump in the valuation. Shares currently trade at 17.8x price/FFO with a 5.7% yield.

They hiked the dividend recently and were in the news last week for another cultivation property. I think the dividend growth could be impressive, and there aren’t many options out there with large starting yields and the potential for significant dividend growth as well. I will be looking to add to my position in the coming months as the risk/reward is heavily skewed to the upside. If you want to read about the company in more detail, here is a link to my most recent article on the company.

AFC Gamma

Advanced Flower Capital Gamma has taken a different route to the cannabis industry. They loan directly to cannabis companies, which is different from the real estate centric approach of the other three REITs. It is a cannabis mREIT with a market cap just over $350M that can generate large yields on their loans. The valuation is too cheap in my opinion, with a single digit P/E ratio and a 12% yield.

Yields that high are often a red flag for investors, but I don’t think investors should worry too much about it with AFCG. Since the first dividend last year, the quarterly dividend has been hiked from $0.38 to $0.55. It’s only a matter of time before the rest of the market wakes up and takes interest in a double-digit yield that has been growing each quarter. I talk about the company in more detail in a recent update here.

Power REIT

Power REIT is the last REIT that I own. It is the most speculative of the four and has a market cap just over $100M. I bought a tiny position in the last couple weeks. Power REIT has continued to grow at a rapid pace since transitioning its focus to cannabis greenhouse properties, but the company also owns a railroad lease and solar farmland. Investors should be aware of the related party relationships with some its tenants and the recent write off at the end of the year for 2021.

The valuation is attractive, especially if the company can grow at the projected rates. With a price/FFO of 14.5x, shares could be much higher in a couple years. The dividend initiation should follow if earnings grow significantly. While I think the company could have a lot of upside, I have kept my position in PW very small. The lack of dividend is one reason, but I also want to see if there are any related party issues spring up with tenants. Power REIT is only an option for risk tolerant investors, but I have well over 90% of my money invested in cannabis REITs in the other three choices listed above. If you want a more detailed breakdown of the company, here is a link to yesterday’s article on the company.

Conclusion

The cannabis industry is a complicated industry to understand. Regulations vary from state to state, and the federal government has been dragging its feet with changes that would benefit everyone involved. SAFE Banking is coming (eventually), which will allow the companies to transition from the cash business that creates logistical problems. It should also allow institutional capital to flow into the sector. Another significant change could be an update to 280E, which prevents operators from deducting expenses and forces companies to pay high effective tax rates.

These changes would dramatically benefit MSOs, but it will likely be a different story for cannabis REITs. Cap rates will likely compress, and competition will increase, but I think the incumbents will have an advantage. Growth might slow down, but it will take time and regulatory change for all of this to happen. IIPR, NLCP, and AFCG will continue to be some of my favorite picks, and I plan to add at the current prices. PW is more speculative, but I will be waiting to see how the company does over the next year and how well it handles the related party tenants. Overall, I think the risk/reward is skewed to the upside and I plan to own a piece of the cannabis real estate market for years to come.

This article was originally supposed to be one article, but I had to break it into two pieces due to the length. Keep an eye out for part 2. It will cover the multi state operators, like Trulieve (OTCQX:TCNNF), Verano (OTCQX:VRNOF), Green Thumb (OTCQX:GTBIF), Curaleaf (OTCPK:CURLF), and Cresco (OTCQX:CRLBF), as well as several other smaller companies. I will go into a summary of each company and talk about potential catalysts for the industry. While I love the rapidly growing REITs in the cannabis sector, the MSOs provide the average retail investor with a chance to front run Wall Street in a sector that is poised to explode in the coming decade.