NewLake Capital Partners: A Small Cap REIT With An 11.3% Dividend

The Potential Long-Term Rewards Are Far Greater Than The Short-Term Risks

Summary

• NewLake Capital Partners is a net lease REIT focused on the cannabis sector.

• Due to the lack of capital available to the sector, NewLake is able to get double digit cap rates with 2-3% escalators and long lease terms. They reduce some of their risk by focusing on limited license jurisdictions.

• There are risks related to the regulatory environment, but in my opinion, those should get resolved in the next couple years. I think it is a matter of if, not when, we will see favorable changes to tax and banking regulation in the sector.

• Even if it takes longer to resolve these issues, investors can collect an 11.3% dividend assuming a steady payout. Management has also been buying back stock over the last couple quarters.

• It’s a small position in my portfolio and I’ll be reinvesting dividends as long as they stay undervalued. Shares currently have a price/FFO multiple of 8x.

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I’m a huge fan of buying out of favor assets, and many REITs have had a rough couple years as interest rates have risen. While most of my portfolio is focused on energy, I do think the real estate sector is an interesting opportunity set right now. My first post on Real Estate Investment Trusts (REITs) was about a month ago on Vornado VNO 0.00%↑, an office REIT focused on Manhattan.

Today’s post is on another REIT in an out of favor sector. NewLake Capital Partners is a REIT focused on industrial cannabis real estate with a market cap of $297M. Now I understand that some people stay away from certain sectors for personal reasons (I avoid investing in pharmaceutical and military industrial complex companies myself), but I think NewLake is an interesting small cap opportunity that is a good business with plenty of growth potential. Shares received a nice bump last week on the news that the government is looking to move cannabis from a Schedule I substance to Schedule III.

Industry Overview & Risks

The biggest risk I see with the whole cannabis industry is the regulatory environment. One of the things that has been difficult for operators in certain jurisdictions is that the tax burden at the state level has made it very difficult to compete with the black market. At the federal level, the 280E tax code has restricted the deductions that cannabis companies can use.

Under Schedule I, the IRS prohibited cannabis touching companies from deducting numerous expenses and caused MSOs to have effective tax rates well above 50%. In fact, most MSOs experienced large federal income tax bills even though they were reporting significant losses. Observers believe moving marijuana from Schedule I to III will remove the yoke of 280E by allowing MSO companies to deduct expenses in calculating taxes just like other companies.

On top of this, major financial institutions have avoided investing in cannabis operators (debt or equity) because of the legal uncertainty in the sector. The so-called SAFE Banking Act has been stuck in legal limbo for years, but its passage (it’s a matter of when, not if, but just don’t ask me when) would allow financial institutions to serve and invest in the sector. The sector still needs capital to grow, and it has created a market that several REITs have been trying to fill over the last couple years.

Several REITs have gone public to provide capital to operators, either through leasing cultivation and processing facilities, or by loaning to operators. I’m avoiding the mortgage REITs that focus on the debt side because I think the risk/reward is better for net lease investors. The first net lease REIT on the scene was Innovative Industrial Properties IIPR 0.00%↑, which is the largest cannabis focused REIT with a market cap of $2.5B. Shares are up more than 400% and the dividend is up 12x since the middle of 2017 when IIPR went public. Their shares are listed on the NYSE, which has given them easier access to capital markets than NewLake, which still trades on the OTC market. NewLake is looking to follow in IIPR’s footsteps, with a more disciplined approach.