Power REIT (PW) – a differentiated REIT in the cannabis space
Market Cap: $45.4mm
Debt: $4.0mm (plus 144mm Series A 7.75% Cumulative Preferred stock, $25 par value)
2021E FFO: $1.80
Forward FFO Multiple: 13.3x
I’ve been doing some work on some various small and microcap REITs lately and came across an interesting one in Power REIT (disclosure: no position). I’m intrigued after doing some initial due diligence and speaking to the management team, but the short operating history of their new business strategy as well as need to raise additional capital is going to keep me on the sidelines for now. With that said, the business is growing fast, takes a differentiated approach to serving as a landlord, has been able to fetch outstanding lease terms, and serves as sort of a ‘pick and shovel’ for the cannabis industry as the market continues to grow. I know for most investors one mention of the word ‘cannabis’ as it relates to stocks causes their gag reflex to trigger, but I’d consider PW one step removed from the actual business (not a grower, not a retailer etc.) and has found a nice niche as a landlord within the space.
Power REIT is a real estate investment trust that owns real estate related to infrastructure assets including properties for Controlled Environment Agriculture (CEA or greenhouses), Renewable Energy and Transportation. PW was founded in the 1960s to acquire railroad assets (more below) in agreement with a 99 year(!) lease with no modification or escalation options. In addition to PW’s newly acquired greenhouse operations, they also own a portfolio of real estate related to solar energy. In short, the current portfolio consists of six greenhouse facilities, seven solar farm ground leases, and 112 miles of railroad. PW’s legacy assets consist of railroad track located in the Marcellus Shale territory leased to Norfolk Southern as well as 600 acres of land leased to utility scale solar farms. These legacy assets (read about the details in the filings) generate around $2.0mm in rental income (on triple net leases) per year, or around $0.15-0.19 in core FFO. While PW trades at a very high valuation taking into account just the core FFO from legacy assets, the legacy properties have provided a stable base of operating results over the past few years and provide some downside protection (although minimal).
The company’s new business strategy is where things get interesting, and take PW from a a no-growth microcap REIT paying below market rents with no way out of their current lease terms to a high growth acquirer of cannabis assets set to increase FFO into the foreseeable future. Chairman and CEO David Lesser (owns, 20%+, more below) started buying shares in PW over a decade ago and began acquiring land underneath solar farms as a way to try and transform the business. He has now pivoted to the cannabis space, and in 2019 launched a new business plan focused on acquiring CEA – or greenhouse – real estate to participate in the growth of the cannabis industry and the need for indoor growing facilities. Since implementing this strategy, PW has acquired 26 acres of land with 130,840 sf. of greenhouse/processing space for medical cannabis cultivation (in place and under construction). PW now owns five properties related to CEA agriculture generating over $2.4mm in annual rental income, and these leases as well as new acquisitions are poised to grow FFO at 20%+ for the next few years. One recent small acquisition for example led to FFO growth of over 30%, and since the first acquisition in 2019, core FFO has grown from $0.14 in the second quarter of 2019 to $0.29 in the second quarter of 2020, or 107%.
The acquisition economics and lease terms for acquired CEA assets have been phenomenal so far, which can be attributed in part to the lack of traditional capital and banking services available to cannabis retailers, operators and growers. For cannabis assets, PW structures their leases as triple net, with a six month rent-free deferral period followed by a 36-month full return of capital amortized monthly via rent payments. So after 42 months PW will have recovered their entire investment, at which point the rent structure switches to a 12.5% return on their original capital invested, increasing 3% per year. Should marijuana become legal in all 50 states, the post-42 month rent will be adjusted down to reflect a 9% return on original capital invested, still increasing at 3% per year. It would be fair to wonder if these rates will be sustainable, but according to management, all of their tenants are thrilled with the arrangement, and competition remains virtually non-existent. As someone with a short background / contacts in commercial lending, I can tell you that the traditional banking industry is nowhere close to lending to these types of businesses. They won’t even begin to underwrite the deals.
To give a quick example of a recent acquisition, PW acquired ‘Sweet Dirt’ (now their largest cannabis tenant in terms of rental income) in May 2020. PW invested $4.9mm to acquire the property in Eliot, Maine including add-ons and construction extensions. They entered into a 20 year triple net lease with the tenant at the terms stated above, and are now collecting $919k in annual rent, driving an 18% FFO yield. They will have recovered their initial investment 42 months from May. Not bad. Moving forward, if PW can deploy additional capital at scale they should be able to add a few million in incremental FFO over the next few years.
Speaking more to lease terms, according to management there is a ton of capital flowing into indoor growing facilities right now. Indoor growth facilities cost the same or more to construct than outdoor facilities, but are more expensive to maintain. While the economics of your typical greenhouse aren’t great (AeroFarms for example has the largest ‘vertical farm’ in the world in terms of annual capacity producing over 2 million lbs. of greens per year at a cost of around $3.00/lb. at maybe 40-45% gross margin), cannabis growers realize selling prices much higher than say a head of lettuce. Again, with similar cost to build both indoor growing facilities and greenhouses, but with greenhouses costing less to operate (and where you have tenants selling a much more expensive product), some of those higher sale prices can be ‘passed along’ to your landlord in the form of higher rent. Add in the fact that there are few other providers of capital and you wind up getting the terms that PW does on their acquisitions and leases.
In short, we’ve got a REIT operating in an industry with limited competition/capital, forecasting 20%+ growth rates over the next 2+ years, with an even larger pipeline of opportunities, being run by a manager who owns 23% of the shares and treats those shares as valuable currency. Not a bad setup.
Power REIT’s strategy shift comes on the back of explosive growth seen throughout the cannabis industry in all sectors. I’m not going to argue the use cases or benefits of medical marijuana, but it’s clear that the industry is here to stay. As of today, 74% of the US population has legal access to marijuana, and recreational / medicinal marijuana sectors are expected to grow in the low to high teens through 2025 to a $12.5 billion dollar industry size. While industry growth is still hampered by state and local regulations (as well as financial; and as a side note there is an enormous opportunity lying in wait for banks / credit unions / traditional finance as soon as the stigma wears off) total legal sales of marijuana are expected to reach the $25-30mm range by 2023, with recreational demand even higher. I don’t have much insight right now into regulations surrounding growing facilities (permits, licenses etc.), nor what more supply will do to pricing throughout the industry, but as growers expand and new capacity is built, industry participants will need land and sustainable places to grow.
Chairman and CEO David Lesser (25 years in investment and real estate experience) started buying stock in PW ten years ago and wanted to use his share ownership to try and transform the business from a no-growth REIT into something different. Shortly after PW started acquiring land beneath solar farms in the energy space, they then pivoted into the cannabis space.
David currently believes the acquisition opportunity is multiples of the company’s current market cap, and investor materials point to a $250mm acquisition pipeline in various stages of negotiation. I’ve spoken with David Lesser and came away impressed. I really like how he’s thinking about running his business as well as his thoughts surrounding the current opportunity set. It’s clear that PW is in the early stages of sizeable potential growth. As mentioned above, the future of the business will come down to their ability to raise capital and lower their overall cost of capital. PW is acquiring and funding expansions for small, upstart types of cannabis growers. While I don’t believe this is necessarily risky, these businesses currently don’t have other options for capital other than at loan shark type rates, driving up their cost of capital. It’s a tough industry to try and raise money. David has explained that it’s kind of a blessing and a curse as cannabis is driving the opportunity set but also limits access to financing. I found it very comforting that he also mentioned his unwillingness to issue stock given their growth rates. Decent financing options have been so hard to come by that PW has even tried crowdfunding! He did indicate that PW has several term sheets out right now (multiples of what they currently own is what I was told) and the pipeline is pretty significant moving forward.
Of note, David Lesser has experience in the publicly traded REIT space, having sponsored the merger of two real estate firms in 1997 – through his investment firm Hudson Bay Partners – into a small cap REIT called Keystone Property Trust. Keystone grew through acquisitions using stock and secondary offerings and was ultimately acquired by Prologis in 2004 for a total EV of $1.5 billion, representing a 20% IRR over that time period.
Moving forward, it seems as though PW is now focused on IR efforts and strategic investor outreach.
PW management is guiding for $1.80 in FFO for FY21. That would value the shares at 13.3x FFO, below it’s closest peer Innovative Industrial Properties (IIPR). Although PW would deservedly require a discount given the lack of operating history, float and the fact that it is a microcap, if management can continue to acquire properties at favorable cap rates w/ high earnings yields, the shares should trade north of 20x FFO.
Long-term fixed rate bonds in the amount of $15.5mm were issued in late 2019 in order to bolster the acquisition war-chest, and if the runway for acquisitions is long enough and management can deploy the capital wisely, they should be able to grow FFO at high rates moving forward. If their biggest problem is lack of access to capital as opposed to competition or some operational issues, I’d like to think that they can remedy the situation favorably somehow.
Using the above acquisition example of Sweet Dirt (as well as the acquisition of another CEA property, Maverick), if PW is able to deploy even half of the $15.5mm at similar cap rates / yields / rates of return, they would be able to add an additional few million in incremental FFO over the next few years. This is not insignificant for a business that did just north of $2.0mm in revenue during 2019. In addition, the long term nature of the debt / bonds, long-term leases from both CEA properties and legacy leases, and gross book value of the properties (around $35mm) provides some margin of safety at current prices.
This isn’t a business that warrants a large position sizing at this stage, but a 1-3% weighting seems appropriate to participate in the capital allocation story and monitor the execution of the strategy moving forward. If investing in microcaps is more about management execution than valuation (it is), than this will be a very interesting story to monitor. I’m assigning zero upside to any indoor agriculture trends the company is able to take advantage of in the coming years. There is nothing material taking place at this stage, but consider those somewhat free options.
Risks / Mitigants
PW is just acquiring sub-par assets at high cap rates – I’d spend some time reading about the recent acquisitions, the businesses behind them and the importance of the facilities to the neighboring towns / states
Legalization is somewhat of a risk. Obviously when all marijuana related businesses are safe to operate in each state there will be tons of competition as well as a flow of capital into the industry. PW will no longer be the buyer of choice. As a result, PW has negotiated into all of their deals a decrease in rental income should marijuana become legal. David said they are interested in building long term relationships with their tenants and did that as a courtesy. Said that their tenants were very surprised and happy about that.
Need to rely on capital markets to grow – discussed above, a big hurdle
Acquisition based model moving forward – have to continue to pay favorable prices. So far, results have been very good
Short operating history in cannabis – industry set to grow favorably moving forward and PW is one step removed as a landlord
Lack of deal flow – doesn’t seem to be a concern according to management
Competition – almost non-existent at this stage given the industry stigma
Lease rates dropping due to increased supply / banking regulation changes
Tenant Concentration – depend heavily on one large cannabis tenant and their legacy properties – legacy assets provide some protection with long-term leases and tenants should diversify over time