Is This Cannabis Focused REIT’s Best Days Behind it?

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Written By Kevin MacDonald

NewLake Capital Partners is a cannabis-focused REIT that owns 14 industrial cultivation facilities and 17 dispensaries in states with limited licenses, leased to about a dozen tenants.

Despite its promising business model and high dividend yield, the REIT has been overlooked by investors, primarily due to its small market cap of $420 million and OTC trading status.

This has resulted in the stock trading at a significant discount to its more established peer, Innovative Industrial Properties (IIPR), listed on the NYSE. This discrepancy created an attractive opportunity to buy a high-dividend-paying stock with substantial potential upside.

Performance Recap and Current Valuation

Credits: DepositPhotos

Over the past year, several bullish sentiments urged investors to consider this underappreciated stock. Since June last year, the stock has returned an impressive 85%, compared to 25% for the S&P 500.

The bullish thesis was based on several factors:

Potential Reclassification of Cannabis:

The anticipated reclassification of cannabis to a Schedule III substance promised to significantly reduce the tax burden on cannabis operators, thereby improving their rent coverage.

High Dividend Yield:

The stock offered a high double-digit dividend yield, which was well-covered with a payout ratio of 75-80%, below the management’s target of 80-90%.

Attractive Valuation:

The REIT traded at an implied cap rate of over 11%, which was considered cheap. The spread to 10-year treasuries was expected to decline, potentially boosting the stock price to $22 per share.

With the DEA’s recent announcement about moving forward with cannabis reclassification and solid Q1 2024 results, NLCP trades at $20.50 per share, just 6% shy of the price target.

Bullish Catalysts Have Played Out

The DEA’s confirmation to reclassify cannabis to Schedule III has been a significant catalyst, driving a recent 10% jump in NewLake’s stock price.

This change, supported by President Biden, aims to move cannabis to a less restrictive category, reducing the tax burden and increasing operators’ profitability by as much as 20%.

While this reclassification is a significant industry development, it now appears fully priced into the stock.

Fair Valuation

On a P/FFO basis, NewLake trades at 10.5x FFO, which might seem low compared to more established REITs like Realty Income (O). However, considering NewLake’s small size and unproven track record, this valuation is justified.

A comparison to IIPR, which trades at 12.5x FFO, supports this view. Additionally, NewLake’s implied cap rate of 9.5%, representing a spread of roughly 5% to long-term treasury yields, is now closer to justified levels after previously being much higher.

Therefore, most of the upside to the price target has been realized.

SAFER Banking Act Threat

The SAFER Banking Act could improve financing access for cannabis operators, potentially undermining NewLake’s sale-leaseback model. This model has been advantageous for both NewLake and cannabis operators due to the latter’s limited access to traditional financing.

With the Act’s passage, operators might pursue different financing options, making it challenging for NewLake to maintain high rents. While this is not an immediate threat given the long WAULT of about 10 years and the unlikely passage of the Act before the election, it is a long-term risk to consider.

Recent Earnings Highlights

In Q1 2024, NewLake performed well, with revenue and FFO increasing by about 10% year-over-year. This growth was mainly due to improved collections from its largest tenant, Revolutionary Clinics, which had not paid rent last year, resulting in low overall collections of only 92% in 2023.

Increased collections led to another quarter of dividend growth, with the dividend now at $0.41 per share, yielding 8%, well covered by FFO per share of $0.50.

Credits: DepositPhotos

Although the portfolio’s growth beyond recapturing previously uncollected revenue has been modest (around 2%), the fact that it is now 100% leased with full collections is positive.

The portfolio’s high EBITDA coverage of 3.9x for cultivation facilities and 9.5x for dispensaries is expected to improve further once the Section 280E tax is eliminated.

Significant Catalyst

NewLake has been a successful investment, with a significant catalyst playing out as expected and the stock price nearing the target.

Given the realization of most expected upside and potential long-term risks related to the sustainability of NewLake’s business model, it may be time to consider taking profits and trimming the position.


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