Innovative Industrial Properties, Inc. (IIPR) Q2 2017 Earnings Report, Transcript and Summary

Good afternoon and welcome to the Innovative Industrial Properties Incorporated Second Quarter 2017 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Brian Wolfe. Please go ahead.

Thank you for joining the call. Presenting today are Alan Gold, Executive Chairman; Paul Smithers, President and Chief Executive Officer; and Catherine Hastings, Chief Financial Officer. Before we begin, I would like to remind everyone that statements made during today’s conference call maybe deemed forward-looking statements within the meaning of the Safe Harbor of the Private Securities Litigation Reform Act of 1995 and actual results may differ materially due to a variety of risks, uncertainties and other factors. For a detailed discussion of some of the ongoing risks and uncertainties of the company’s business, I refer you to the news release issued yesterday and filed with the SEC on Form 8-K, as well as the company’s reports filed periodically with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Before I hand the call over to Alan, I want to mention that we have limited time for the call today, but we will answer as many questions as we can after our prepared remarks. Alan?

Thank you, Brian, and welcome everyone. Today, we get a chance to review and share our financial results for the second quarter plus year-to-date 2017 and provide our updated perspective on the business and the industry from our last call in March of this year. On the operational side of our business, our top priority continues to be placing the balance of our proceeds from the December IPO in the best properties and with the best tenants for the long-term benefit of our stockholders. We took another major step this quarter toward completing this – that goal, with our purchase of the property in Capitol Heights, Maryland, a 72,000 square foot building being developed as the start-of-the-art medical-use cannabis cultivation facility. The property is a 100% leased to Holistic Industries for an initial term of 16 years. Holistic is one of 15 companies to receive pre-approval by the Maryland Medical Cannabis Commission to cultivate medical-use cannabis. And one of only three companies to have received licenses enabling full vertical integration, cultivation, processing and dispensing. In addition, after only our second full quarter of operations, we were able to pay a quarterly dividend of $0.15 per share to stockholders of record as of June 30, 2017 having generated $0.23 of adjusted funds from operations per diluted share during the first six months of the year, truly a remarkable achievement for such a young company. Catherine, who I am very excited to say, was promoted to CFO this quarter will provide more detail regarding our financial results. As we discussed in our last call, the medical-use cannabis industry is constantly evolving. Including the strong growth of existing state markets, the rollout of new programs passed the numerous states by a popular vote or legislation in recent years and the change in the presidential administration. Paul will provide further perspective on these changes and other industry trends in our call today in addition to discussing in further detail our two properties and pipeline. This nascent industry that has witnessed amazing growth with state regulated medical-use cannabis markets, now comprising a majority of the United States. We are very optimistic about the future of this industry and our ability to deliver an enduring value to our tenant partners in providing tailored real estate solutions that meet their key operational and capital needs. Now with that, I would like to turn the call over to Paul. Paul?

Thanks, Alan. As Alan alluded to this is a rapidly evolving industry. I’ll try to provide as effective an overview as we can with the short-time we have today focusing in on four main topics: one, the current regulatory environment; two, the growth and evolution of the medical-use cannabis markets in the United States generally; three, an update on the New York and Maryland markets and our two tenants at those properties, PharmaCann and Holistic Industries; and finally, our pipeline. First, regarding the current regulatory environment. As you all know, there's been much discussion over the past number of months about a reevaluation of the federal government's enforcement posture as it relates to the cannabis industry. To summarize the current status, the Cole Memorandum is still the guiding directive of the DOJ and DEA, which characterizes enforcement of federal cannabis prohibitions under the Controlled Substances Act as an inefficient use of federal resources when state regulatory measures are in place that are effective in addressing federal enforcement priorities laid out in the memo. In addition the Rohrabacher-Farr amendment is also still in place, which provides that the DOJ could not use funds from relevant appropriation acts to prosecute individuals for any compliance with the state medical-use cannabis laws. The amendment has been in place for over two years now with increasing congressional support each year. In late July renewal of this amendment was recommended with overwhelming support by the Senate Appropriations Committee to be included in the federal government spending bill for fiscal 2018, which will make its way through the Senate and then generate reconciliation with the House version later this year. These are in addition to the numerous other initiatives taken by Congress including the establishment of the bipartisan Congressional Cannabis Caucus this year and the introduction of a number of bills in the 115th Congress in favor of various forms of cannabis legalization on the federal level. And just last week, a new bill the Marijuana Justice Act of 2017 was introduced in the Senate, which proposes among other things to de-scheduled cannabis. Now on to a general update of the medical-use cannabis markets nationwide. The industry continues to move forward with tremendous philosophy. States legalize medical-use cannabis by popular vote or legislative process now comprised a majority of the U.S. with over 200 million residents. Medical-use cannabis continues to pull with 80% plus popular support in the United States and the cannabis industry continues to be a leading driver for U.S. jobs and tax revenues. In fact a study by Leafly in January 2017 estimated approximately 123,000 full time jobs have been created to support the state regulated cannabis industry with revenues that contributes billions of tax dollars to states to fill funding shortfalls. With recently approved measures for both medical-use and adult-use cannabis in a number of states, we expect growth to remain strong. Drilling down a bit on New York and Maryland, where our two properties are located, we see two early stage markets with tremendous potential. As you may recall, we purchased our New York property in December 2016 in a sale leaseback transaction with PharmaCann for a 15 year initial term at an all-in yield of about 17% on a triple-net lease basis. PharmaCann is a multi-state operator with two cultivation facilities and four medical-use cannabis dispensers in Illinois and our cultivation facility and four medical-use cannabis dispensers in New York. PharmaCann has also been awarded licenses in Massachusetts, Maryland and Pennsylvania. Our New York property is about 127,000 square feet and construction of the facility was completed in mid-2016. As discussed on our last call, New York's medical-use cannabis program has initially rolled out has been described by many as one of the most restricted and highly regulated while New York’s first year of operation was only last year. First year’s sales of $36 million were viewed by many as falling far short of expectations for the first year. In response and in order to enable broader access to treatment, New York has taken several positive steps in recent months including expansion of the pool of potential recommending health professionals to include nurse practitioners and physician assistants allowing for home delivery of the medicine, the streamlining of the registration process for practitioners and certification process for patients and perhaps most importantly the introduction of chronic pain as a qualifying condition. Our few market research in consideration of the changes made in the program, the market potential and the estimated overall size of the illicit market in New York of nearly $3 billion has estimated $254 million of sales in New York's legal market by 2021 representing a compound annual growth rate from 2016 of 48%. We’re seeing encouraging signs of that anticipated and accelerating growth and the early stages of the impact of the regulatory changes in New York’s available state level data. Patient count has increased more than 70% since the addition of chronic pain as a qualifying medical condition in March of this year with over 25,000 patients registered as of the beginning of this month. Now, on to our Maryland property. On May 26, we entered the Maryland market with our purchase of 9220 Alaking Court in Capitol Heights, a well located property under development has expected to be approximately 72,000 square feet upon completion. Our initial purchase price was approximately $8.2 million including transition costs with an additional $3 million payable to the seller upon completion of certain development milestone. And an additional $4 million payable to the tenant, Holistic Industries, as reimbursement for certain tenant improvements. Concurrent with the completion of the purchase, we entered into a triple-net lease agreement for an initial term of 16 years in Holistic, which intends to use the facility for medical-cannabis cultivation. Subject to our rent reserve that we established in an initial three months of rent abatement, the initial base rent is expected to be 15% of the sum of the initial purchase price, the additional seller reimbursement and the reimbursed tenant improvements with 3.25% annual escalations for the initial term of the lease with the first escalation being June 30, 2018. Holistic is also responsible for paying the company 1.5% property management fee of the then existing base rent under the lease. Holistic is one of 15 applicants in the State of Maryland to have reached provisional approval for the cultivation of medical-use cannabis by the Maryland Medical Cannabis Commission and one of only three applicants to have received provisional licenses for processing and dispensing as well allowing for full vertical integration of its business. On August 1, 2017 with the seller having satisfied its obligations with respect to the achievement of the development milestones, we paid the additional $3 million to the seller. Although still in its rollout stages, we're optimistic regarding the development of the legal medical-use cannabis market in Maryland driven by Maryland's population size and anticipated demand, the inclusion of PTSD in chronic pain among the initial qualifying conditions and the general view from regulators and policymakers that the industry represents economic development opportunity notwithstanding the initial delays and litigation surrounding the rollout of the program. We are thrilled to have Holistic as our second tenet with its seasoned management team that embraced decades of experience in executive management, agriculture business, health and medical science including the longstanding ownership, management in the operation of successful medical-use cannabis cultivation and processing facility in Washington D.C. and provisional approval for cultivation and dispensary operations in Massachusetts. We recently filed Holistic’s financial statements with the SEC on an amended current report on Form 8-K and I encourage you to review that information. As you will see from that information, Holistic is in start-up mode and has not yet commenced our operations, but has received $9 million in capital commitments for its operations. We look forward to supporting Holistic at this facility and looking for ways to partner with them as we expand operations in Maryland and elsewhere. Now on to our acquisition pipeline. As Alan mentioned, we are intensely focused on investing the remaining proceeds from the IPO in the best opportunities, high quality assets, top-tiered tenants with strong balance sheets and management teams in a stage where we have confidence in the regulatory environment. We're taking a highly selective and disciplined approach to our capital allocation and we have passed on a number of potential investments based on our underwriting criteria and return requirements. That said we're in advanced discussions regarding a number of potential acquisitions with a pipeline of approximately $100 million spanning a number of states including Arizona, Illinois, Maryland, Massachusetts, Ohio and Pennsylvania to name a few. We are also closely monitoring developments in California and are engaged in numerous discussions with high-quality cultivators there as the states continues to develop its regulatory platform and prepares for the issuances of licenses. As with any emerging dynamic high growth industry, we are adopting our acquisition strategy and criteria accordingly. We are seeing excellent opportunities in our pipeline that includes both near-term opportunities and longer dated investment opportunities. I'll now turn the call over to Catherine, who will walk you through our financial results for the second quarter and year-to-date 2017. Catherine?

Thanks, Paul. Having completed our IPO in December 2016 and having begun real estate operations shortly thereafter with our initial property acquisition in New York, our second quarter 2017 represents just our second full quarter of operations. We had total revenues of $1.3 million in the second quarter of 2017 and $2.6 million during the months ended June 30, which reflected PharmaCann’s cash rents paid for applicable time period. As Paul discussed rent for our property in Maryland, which we acquired in May, is subject to an initial rent abatement of three months. We recognized rental revenue for both leases on a cash basis and expect to begin revenue recognition for our Maryland property later this month. For the three months ended June 30, 2017, the company recorded a net loss of $422,000 funds from operations, which adds back property depreciation to net loss with a loss of $247,000 and adjusted funds from operations which adds back non-cash stock-based compensation expense and severance paid to our former CFO to funds from operations was the positive $471,000. For the six months ended June 30, 2017, we recorded a net loss of $1 million of funds from operations loss of $677,000 and adjusted funds from operations of positive $811,000. And Alan mentioned on July 14th, we paid our first quarterly dividend of $0.15 per share to stockholders of record as of June 30. This dividend represents approximately 65% of our AFFO per diluted share of $0.23 for the six months ended June 30. With that I would like to turn the call back to Alan. Alan?

Thanks, Catherine. It has been a very eventful first few months as a public company and we are excited about the opportunities to come. I want to thank the stockholders for your continued support and we look forward to continuing to service this very promising industry as a long-term real estate and capital provider and to creating sustainable long-term value for our stockholders. With that I'd like to open it up to questions. Operator, could you please open the call up for questions.

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Dan Donlan with Ladenburg Thalmann. Please go ahead.

Thank you and good morning.

Good morning, Dan. How you’re doing?

Good, good. I just wanted to talk about the pipeline of $100 million. It's roughly on par to what it was, I think, in May early this year. Just kind of curious did you – have you seen some properties drop out of that? And then as a follow-up to that, could you maybe characterize the range of cap rate that you're looking at and maybe the size of transactions you’ve had? You've done something for about $15 million, you’ve done one for about $30 million. Can they go as low as $5 million? Just kind of curious if you could give us a little bit more characterization there?

Okay. Well, so, yes, yes, it was about the same size. And I think it will – as I've been in this industry for – in the real estate industry for many years, the pipeline will continue to evolve and we can certainly talk about a much larger pipeline than $100 million. But we're comfortable with that because it makes sense with the amount of capital that we have available to ourselves. And it doesn't make sense to throw everything in and that we've been receiving on the pipeline and throw out a big number.

Sure.

So we have seen transactions fall off the pipeline and for a variety of reasons including our analysis of the real estate and the underwriting of the management team. And so, we have seen that and we have seen new and very exciting transactions come back on or coming through the pipeline. Transactions on the pipeline range anywhere from $3.5 million to $4 million and size range up to $50 million to $60 million in size range. We've seen transactions up to that size. Our pipeline is ranging anywhere from $3 million to about $20 million in size, okay. The cap rates, we've seen people looking for yields or trying to do transactions as high as 20% and as well as 10% to 11%. We're still focused on doing high quality transactions with the highest quality growers that have the greatest amount of experience and strong management team and most importantly very strong financial backers and looking at yields ranging in the – from the 14% to 16% range.

Okay, that's very helpful. And then in terms of competition, you're maybe the only publicly traded REIT that is focused on this and can be focused on this. You know given those yields, have you seen kind of more private companies come into the business and start to look at this? Just kind of curious is you’re underwriting acquisitions if you're running up against the type of private companies you maybe running up against has that changed at all since the IPO?

I think that there has been the change. There – initially I think that there were – a lot of the competition was from the groups that are looking for or to raise capital and they're looking at it from a variety of different – our growers who are looking to raise capital look at to raising capital from a variety of different sources, including real estate companies such as ourselves and private equity or private capital from the broader market. What we're seeing is that some of that private market capital has already been placed and there's an increasing demand for – for the consistent type of capital that we can provide. We aren't seeing any new real estate players really come into the market. We've heard of a group up in Seattle trying to raise a fund, but haven't raised the fund. We know of Kalex reverse merger, but we haven't seen them actually placing any of the capital yet, although we believe that they're out there competing and will be a strong and confident competitor. So we still think that we are in the first mover pioneer position. We still believe that we have a very strong reputation in brand and the best growers are looking to partner with us and we're very excited about the opportunities we have in front of us and going forward.

Okay, I appreciate that. I've got one more general question and just two housekeeping ones if you don’t mind. Just talking about the regulatory environment, it seems that the New York market, the restrictions on the qualifying conditions have held that market back now that you have chronic pain has really accelerated dramatically in terms of the patient population. So just kind of curious do you see that hoping in enough other opportunities in markets in terms of – can you just give the growth you’ve seen in New York? And then maybe just on the technology side or the science behind some of these – some of the cannabinoids and things that they're producing. Is the science gets better, do you think that helps some of the profitability increase in the sales? I mean I guess what I'm asking is how much is the improvement in science is going to help as much as maybe reducing some of the regulatory hurdles that that exist.

Oh, I met on a complicated question. There's a lot of thing. I mean there's some really interesting science that is occurring and that’s – and with any evolving product type that's going to be – that is going to help the industry certainly with the testing and being able to test and provide a higher quality and more consistent type of products. That is going to be helpful. But I think what you're seeing is the push and pull of – moving product off the black market and patients away from the black market and into the – what we think is a much safer and the better – the safer market of being buying from the medical marijuana providers with approved licenses and approved dispensaries. It’s really what you're seeing right now. And there's a tremendous amount of growth and opportunity for that to continue and to provide tremendous value for our growers and wholesalers. And hopefully, we believe science is coming rapidly to the industry. We think we see – we continue to see new – actually biotech companies looking at starting up exploring the medical cannabis industry. We've seen other states that don't have a medical cannabis program, relax their rules or regulations to allow universities and research institutions to have the ability to grow cannabis for research. And we think all of that. It will be positive in growing this nascent industry into a very large industry over the long-term.

Okay, I appreciate that and then just Catherine just two housekeeping things here. When does the rent abatement for the Maryland facility burn off? And is that rent abatement will be retroactive for the improvements as well or the rent release just starts – the abatement starts kind of when you invested the first amount of money and then you'll get the rent regardless of when you paid for the improvements, just kind of curious just for modeling purposes there.

Yeah, the rent abatement period burns off at the end of August and then we will begin recognizing revenue for Maryland. So the way that the rent increases work is at 15% on the sum of the initial purchase price and that additional $3 million that we just started in August. So, starting in September we’ll have revenue on to sum of those two.

Cash revenue.

Okay. Right, okay, perfect. And then as far as the cash G&A run rate, we just averaged the first two quarters. Is that good for the back half or with – Rob no longer with the company, is there any bit of savings there, just curious for modeling purposes.

I think using the first two quarters is good for now. We're still moving through the process of making sure that we’re fully staffed and can deal with all the regulatory requirements of being a public company. So I am comfortable I think with the run rate that by averaging the first two quarters.

Okay, perfect. Thank you so much.

Your next question comes from Steve Shaw with Compass Point. Please go ahead.

Hey, guys. I may have missed this. When you were talking about potential target markets, do you have favorite one or two obviously California is probably more mature than the others – might an asset that are not yield as much or what are you – how would you rank those target markets?

So I don't – we don't have a favorite target market. Recall that we are focused on medical-use cannabis and it's very easy for us to be focused on or it’s more important for us to be focused on states, which have only a medical-use environment. Now, we are looking at states that have both medical and adult-use environments. California while we believe will be a favorite market or a very strong market and market that have tremendous opportunities for placing of capital. That regulatory environment is still evolving. The new licensing won't come out until sometime in the first quarter we believe and it could be delayed of 2018 in California. So with that we are being very careful in underwriting our transactions with those growers in California that have a longstanding history in California and in providing product and growing, but our – equally focused in other states where the environment is a little bit more clear.

Okay. And then in terms of the pipeline, I know you discussed that in some detail. Did you guys mention a timing standpoint of something you might be comfortable with in terms of the next acquisition or two?

Well, I mean, on timing process, I mean, we have immediate opportunities that we're very, very confident in right today. But what I want to bring you back to is when we completed the IPO and even after our first call, we made it really clear that we believe that we'll be able to fully deploy the capital within a six to twelve month period of time and we are highly confident that we're going to achieve that goal.

Thanks.

Thanks.

Due to time constraints, this concludes our question-and-answer session. I would like to turn the conference back over to Alan Gold for any closing remarks.

Well, I want to thank everybody for joining us here today. We very much appreciate your spending time with us. And with that we’ll end the call.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.