Many of you know I worked as a commercial real estate (“CRE”) developer back before the Great Recession hit.
When I say I was hands-on with these projects, I’m not exaggerating. That included scouting out plots of land… purchasing them… filing all the necessary paperwork to build on them… and hiring construction companies to turn them into attractive retail properties…
I would regularly walk the sites in progress, meeting with contractors and subcontractors alike. This wasn’t just to make sure everything was going smoothly. I genuinely wanted to learn how to create value from the ground up.
What decisions were they making and why? It’s amazing how much interesting and useful information you can take in when you’re curious enough.
And there’s one job-site lesson that’s applicable for investors.
The raised nail gets the hammer.
You Are the Overseer
If something sticks out that isn’t supposed to stick out, overseers will address that first and fast. The good ones, anyway. The inexperienced, negligent, or outright dishonest ones, of course, won’t until it’s too late.
That’s why shareholders and prospective shareholders must be overseers right alongside management. We might not be able to analyze every individual “nail.” But we can still see when something significant isn’t hammered in correctly.
In income investing, one common indication of a shoddy job in progress is when dividend yields get too high. These stock situations can look incredibly attractive at first glance, we know.
But as I wrote yesterday while addressing “quality, dividend-paying companies,” there’s “no yield chasing for us.” Just like that raised nail on a job site, higher yields often indicate that something either needs to be addressed…
Or it’s all going to fall apart before long.
The Anatomy of an Unsustainable Yield
I know it’s easy to get goo-goo eyes over a 10%, 12%, or higher dividend yield. And there are times when a quality company’s stock has been unjustly devalued enough to produce those numbers.
However, those cases are the exception. The rule is that the business in question is suffering from at least one of the following:
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Declining fundamentals. When earnings – or funds from operations (“FFO”) in the case of the real estate investment trusts (“REITs”) – start to deteriorate, share prices fall, sending yield up automatically.
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Overleveraged balance sheets. Businesses can play fast and loose with borrowing under certain circumstances, including when interest rates are low. But when refinancing costs rise, those same companies have to get creative about paying down their debt… often at the dividend’s expense.
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Nonsensical Payout Ratios. Other times, management makes the move on purpose to attract shareholders. But paying out too much of your cash flow means there’s no margin for error. And errors do tend to eventually occur.
Regardless of the reason, the results rarely change. The company in question has to cut its dividend, and investors sell on the news – creating even more losses for shareholders.
That’s just not a risk I’m willing to take. And while you ultimately have to make your own decisions, I’m always going to try to steer my readers away from “sucker yields” as well.
You just never know when rates might rise, economic troubles might hit, or geopolitical tensions might happen. So it’s much better to stick with a sleep-well-at-night (“SWAN”) strategy, focusing on:
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Durable income streams
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Strong balance sheets
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Proven management teams
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Long-term value creation
That might mean buying into lower yields. But they’re lower yields with a much stronger chance of lasting.
Nailing Down Innovative Industrial Properties
Innovative Industrial Properties (IIPR) is a specialty REIT focused on cannabis-related real estate – specifically cultivation and processing facilities leased to marijuana operators.
Its model is built around sale-leasebacks. Cannabis businesses sell their properties to Innovative Industrial to get cash. And the REIT leases them back under long-term triple-net leases.
This structure worked extremely well for Innovative Industrial in the beginning since tenants lacked access to traditional bank financing. Put simply, banks don’t want to mess with cannabis businesses since they remain illegal on the federal level.
That means associated REITs could charge double-digit yields and hand investors tidy profits as well.
Source: FAST Graphs
However, that happy situation only lasted so long.
The sale-leaseback structure itself is sound, but it still depends on healthy tenants. Which just isn’t proving to be the case long-term.
Too many cannabis operators, we’re learning, are under-capitalized. They’re actually struggling so badly to generate real, reccurring profits, that many are failing altogether.
Those defaults are then affecting their landlords. With more than one failed lease on its balance sheet, Innovative Industrial no longer has the cash flow to cover its dividend.
Its revenue is falling, and adjusted funds from operations (“AFFO”) are down about 25% year over year to $1.71 per share. Yet it’s currently paying out $1.90 per share per quarter.
That translates into a 111% payout ratio. Which, to state the obvious, isn’t sustainable for very long.
Even Innovative Industrial’s Plusses Aren’t Adding Up
On the plus side, management began implementing a major shift last year, recognizing its precarious position. It committed up to $270 million into life-science real estate platform IQHQ, including a credit facility, a preferred equity, and an opening into outright ownership.
But even this venture has its issues. For starters, there’s common ownership between the REIT and IQHQ, opening up the possibility for conflicts of interest against shareholders.
In addition, this is Innovative Industrial’s first real venture outside of the cannabis space, and a big one at that. It reduces its exposure from near 100% to 88% of revenue, altering its focus away from its original specialty.
In fact, Innovative Industrial is increasingly acting more like a lender and preferred equity investor – in short, a capital provider – than a landlord. So we have to wonder how smooth this transition will go.
IIPR is currently yielding more than 14% on its dividend. It’s almost impossible for a REIT to offer that much from a sustainable place. And we’ve already seen how unsustainable the situation really is here.
There are proverbial nails out of place everywhere. And eventually, they’re going to have to get hit. Either that, or this house is coming down altogether.
Regardless, I don’t want to be standing anywhere near the fallout to come. I truly hope you’re nowhere near it as well.
Regards,
Brad Thomas
Editor, Wide Moat Daily
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