Chicago Atlantic Real Estate Finance: A cannabis lender stuck between a rock and a hard place

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Investment thesis

Chicago-Atlantic Real Estate Financing (Nasdaq: NASDAQ: REFI) is a mortgage REIT that lends to state-licensed operators in the cannabis industry. On a valuation basis, REFI is trading at 1.1x P/B and yielding 9%, which is not terribly attractive. On a more concerning note, the legal environment provides no margin of safety for cannabis investors, as REFI is not permitted to acquire title to the underlying real estate while it is being used to conduct business. cannabis-related activities. Such a statutory prohibition will not allow REFI to realize the full value of the “appraised” value. Additionally, if cannabis is eventually legalized, such an event would be detrimental to REFI as larger, more traditional and established players could move into the space.

Background

REFI is a mortgage REIT that completed its IPO in December 2021. It focuses on providing senior (and sometimes mezz) loans to state-licensed operators in the cannabis industry. They are externally managed by Chicago Atlantic REIT Manager and seek to make loans between $5 million and $200 million, typically with terms of 1 to 5 years and amortization when terms exceed 3 years. They typically act as co-lenders in such transactions and intend to hold up to $30 million of the total loan amount.

Loans are secured by real estate (when lending to owner-operators) and other collateral (equipment, receivables, permits, etc.). Some statistics on its current loan portfolio:

  • 23 loans worth approximately $286 million, which consist primarily of first mortgages to multi-state or single-state cannabis operators or landowners

  • The weighted average yield to maturity (YTM) is 17.3%

  • ~55.9% consisted of floating rate loans, 44.1% fixed rate loans

  • All loans had prepayment penalties

Current REFI loan portfolio

Current REFI loan portfolio (2022 10-K)

The stock is currently trading at $17. With ~17.7 million diluted shares outstanding, the company’s market cap/value (no debt and minimal cash of around $6 million) is around $300 million.

Risks

  • Mortgage REITs: mREITs are generally more risky and subject to volatility; mREITs are also usually leveraged, but that doesn’t seem to be the case here.

  • Externally managed: two potential disadvantages of being externally managed are (1) less likely to achieve economies of scale (management/incentive fees increase as fast as assets under management + required payment of majority of profits as dividends) and (2) potential conflict with shareholders (eg, may issue stock below intrinsic value for growth reasons). Nor is there enough historical data to see how REFI’s management will behave in the future.

  • Asset Mix/Binary Cannabis Betting: REFI’s assets are mainly in the cannabis space, which does not offer much diversification in terms of asset class; in other words, you are making a binary bet on the success of the cannabis space. Keep in mind that cannabis is still a Schedule I controlled substance and is not yet federally legal. All kinds of problems arise from the fact that cannabis is still illegal: difficulty in accessing bankruptcy courts, loans to cannabis companies can be confiscated by the government, etc.

  • Doubtful warranty: A few key points caught my attention:

    • REFI is not permitted to take title to real estate while it is being used to conduct cannabis-related activities due to legal prohibitions and stock exchange listing standards. In the event of default and if REFI decides to take possession, it must first evict the borrower from the property, then engage a third party to remove all cannabis from the property before taking possession.

    • Of course, REFI could pursue other avenues in the event of default, such as forcing the sale of the property to another cannabis operator, pursuing a judicial foreclosure through a sheriff’s sale (without taking title ), or use the property for non-cannabis-related purposes.

    • Unfortunately, all of the points listed above are value destroyers for the valuation of the underlying real estate. As noted in the 10-K, “Therefore, the appraisal-based real estate collateral values ​​shown in the table below may not equal the value of such real estate if it were to be sold to a third party. in the context of a seizure or similar procedure.”

    • In addition, appraisal values ​​were based on two approaches: income and replacement cost for a similar installation. If you take out all the “value added” related to cannabis, the replacement cost component becomes meaningless. Which begs the question, “how much is the appraised real estate really worth?”
REFI real estate security coverage

REFI real estate security coverage (2022 10-K)

  • Rising interest rates: we are currently in a rising rate environment. In such an environment, MREIT revenues typically decline because the cost of the money they borrow to fund their operations increases, compressing revenues. This is mixed here since REFI does not appear to have borrowed any money. However, the value of the loan will decrease if interest rates continue to rise.

  • Inflation: in an inflationary environment, you want to take on debt (a borrower) and not provide debt (a lender). Why? Because as a borrower, you will be paying off a debt with money that is worth less. mREITs are unfortunately lenders.

Evaluation

Using data from the last 10-Q:

  • Book value: $286M assets, $16.5M total liabilities → $269.5M book value (1.1x P/B)

  • Dividend: $0.4/sh for the last quarter → $1.6/sh per year → 9% return

  • Earnings per share (“EPS”): $0.44/sh for the last quarter → $1.76/sh per year (9.65x PE, although not a very useful metric since mREIT earnings fluctuate)

  • Real estate security coverage: according to their deposits, the loans are guaranteed by a land value which is worth 1.8x (on average) of the loans; this value is based on their subscription and is “assessed by a third party at least once a year, or more frequently if necessary”. However, I have reservations about the true valuation of the warranty (see my points under Risks – Doubtful Warranty). If you decide to impose a 50% haircut (which I normally do in such uncertainty), you get 0.9x home collateral coverage.

In short, REFI is trading slightly above book value (1.1x), yields ~9% and its dividend is covered by its earnings. From a valuation point of view, REFI is not very attractive; a quick look at BXMT shows it is trading at 1.1x P/B and yielding 8% (roughly the same metrics but with very different risk profiles).

Additionally, a key caveat is that an mREIT’s historical performance is a critical part of its valuation (eg, P/B trends, payout ratio, etc.). However, since REFI just completed its IPO less than a year ago, historical metrics are simply not available. Any formulation of value in the future will be entirely guesswork, which provides zero margin of safety.

Catalysts

  • Insider buying. Two insiders bought in April/May 2022 at $15.50 and $17.95 (~$377,000 in total). Many insiders also participated in a private placement alongside the IPO at $16/sh in December 2022 (~$7.5m in total). The shares were subject to a 180-day lock-up period which will end on June 5, 2022.

  • Federal Cannabis Legalization: the legalization of cannabis at the federal level would greatly benefit REFI, but on the other hand, it would also lower the barrier to entry into the cannabis space, paving the way for larger and more established players (which makes the “edge” of REFI questionable)

Carry

REFI is an interesting company operating in a niche of the cannabis industry. In theory, the business makes sense; Cannabis operators have limited access to traditional bank and non-bank financing, allowing companies like REFI to provide them with attractive loans.

However, in addition to being an mREIT operating in a single asset class, its historical performance limited to only 6 months does not allow analysis of operational performance. Additionally, REFI’s inability to even take possession of the cannabis assets as collateral was the “nail in the coffin” moment in my analysis. As a lender, if you are unable to take ownership of the underlying collateral, it raises the question: what exactly is securing your loans? The appraised value is partially calculated using a cannabis facility replacement cost, which becomes meaningless if you are forced to remove anything cannabis related.

In short, the current legal environment leaves no margin of safety for cannabis investors, especially lenders such as REFI. Even if the legal environment changes (e.g. cannabis is legalized), such action would render REFI’s “advantage” useless, as conventional investors/lenders would be free to move quickly through the space.

From a valuation perspective, 1.1x P/B and a 9% yield aren’t very attractive either (on an absolute or relative basis). A quick look at comparable mREITs shows that they trade similarly to REFIs but with completely different (and likely more attractive) risk profiles and diversification. Moreover, the “appraised” value of the underlying real estate to which REFI grants loans does not have a margin of safety either.

Based on the analysis above, I do not recommend a long position in JJSF (for public short/sell recommendations, like Edwin Dorsey at Bear Cave, I do not hold positions in the stocks I mention and have no intention of initiating a position).

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