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May This Passive Earnings Inventory Be In Huge Bother?

Progressive Industrial Properties (IIPR 2.15%) is a pot actual property funding belief (REIT), a class that principally did not exist earlier than this firm’s preliminary public providing (IPO) in late 2016. From day one, the purpose was to develop together with the fast-expanding marijuana sector. However nothing goes up or down in a straight line on Wall Avenue, and Progressive Industrial is going through the primary actual check of its enterprise mannequin. This is what is going on on and what might occur from right here.

A picks-and-shovels play

When the California gold rush happened within the mid-1800s, some individuals went all in, hoping to strike it wealthy discovering gold. Others bought the instruments these gold prospectors would wish as they mined their goals. Promoting the picks and shovels was a way more dependable marketing strategy. That’s actually the logic behind what Progressive Industrial Properties is doing within the marijuana house, with the REIT proudly owning the amenities used to develop hashish.

Person in an industrial cannabis grow house writing in a notebook.

Picture supply: Getty Photographs.

It isn’t as thrilling a enterprise as rising hashish, however Progressive gives a useful service. Primarily, because it buys property from growers, it helps them fund their growth efforts. In alternate, it will get a long-term tenant. A part of this course of, nonetheless, is that the REIT helps to pay for facility upgrades. This results in increased rents, which is nice.

Nonetheless, these upgrades might turn out to be stranded investments if the tenant stops paying hire. Certainly, a brand new tenant in all probability would not be keen to pay the identical degree of hire, because the upgrades are already in place and needed if the ability goes for use as a develop home.

Up till July, there was nothing to counsel that Progressive’s mannequin was something however profitable. Nonetheless, as in any property sector, there are some tenants that succeed and a few that fall by the wayside. After an excellent run through the preliminary “land seize” amongst hashish growers, Progressive Industrial has its first tenant, Kings Backyard, that isn’t paying hire. Now the rubber hits the street.

What is going on on

Clearly, Kings Backyard is now not paying hire on the properties it occupies. Throughout Progressive Industrial Properties’ second-quarter 2022 earnings convention name, administration famous that this tenant accounts for round 8% of the general hire roll. That may be a important sum and cannot be ignored by buyers. Proper now, Progressive Industrial is doing precisely what you’d anticipate — making an attempt to get Kings Backyard to both pay or vacate the properties. However what do the potential outcomes appear to be?

The very best decision can be that Kings Backyard manages to begin paying hire once more on the pre-existing degree. If that occurs, then there’s principally no change to the REIT’s enterprise. That is in all probability not a high-probability consequence, provided that firms usually solely cease paying hire on important properties (like a develop home) when they’re in extreme monetary misery.

Alternatively, Kings Backyard and Progressive Industrial might work out hire concessions. That might hold the tenant within the property, however would probably imply much less hire will get paid every month. There are various methods this might go. Typically the trail is both decrease hire with a lease extension, or a deferral of hire that’s to be paid again at a later date, presumably when the tenant’s enterprise is on stronger footing. The 2 events are in courtroom proper now, which in all probability is not an excellent signal for this consequence.

Progressive Industrial might find yourself having to evict Kings Backyard. That is good in that it might launch the properties, however dangerous in that it might not be capable to get the identical rental earnings. Furthermore, any investments within the properties for upgrades might find yourself having to be written off. Sadly, this looks like the highest-probability consequence.

That stated, develop homes are extremely particular and extremely regulated, so a brand new tenant is probably not all that arduous to search out. There’s additionally an opportunity that vacated property will get bought as develop homes, which could enable Progressive Industrial to guard among the funding it made within the asset.

One other potential consequence is that Kings Backyard will get purchased and the brand new proprietor takes over the corporate’s current leases. That is the toughest consequence to foretell, and one that you simply actually should not depend on.

In an absolute worst-case situation, Progressive might promote the properties as generic industrial property. This is able to be akin to salvaging as a lot cash as potential from the funding, as a transport firm would possibly do by promoting a tanker ship to the scrap yard. However the hot button is that even on this state of affairs, Progressive Industrial might nonetheless salvage a few of its funding. At this level, it is value noting that Progressive Industrial Properties’ adjusted funds from operations payout ratio within the second quarter was round 82%, leaving some wiggle room for adversity.

Now what

Progressive Industrial Properties’ inventory has fallen materially, a minimum of partly due to the danger posed by this tenant occasion. And that is unlikely to be the one troubled tenant the corporate has ever needed to take care of, so the issues in regards to the enterprise mannequin’s resilience are actual.

Nonetheless, given the long-term development projected for the marijuana sector, it’s extremely probably that the REIT will survive this check and proceed to develop. That might make the traditionally excessive 7.4% dividend yield right here engaging to extra aggressive earnings buyers. Nonetheless, shareholders ought to pay shut consideration to what occurs with Kings Backyard, as a result of it is going to principally be setting the bar for future tenant troubles.