What to Expect in Cannabis Real Estate Deals

07 Dec What to Expect in Cannabis Real Estate Deals

Cannabis real estate transactions can be notoriously complicated – much more so than your average real estate deal. On January 9, 2024, I’ll be speaking on a panel called “Navigating Real Estate Issues Impacting the Cannabis Industry” for the Los Angeles County Bar Association, where my co-panelists and I plan on touching on many of the most precarious issues in these sorts of transactions. Today, I want to preview some of the key issues we see in these kinds of deals.

Location, location, location

The most important factor in any cannabis real estate transaction is location. Licensing authorities impose all sorts of requirements or restrictions on real estate locations, including:

• Zoning laws are usually hyper restrictive for cannabis companies. Cannabis businesses may be relegated to very small areas within a city. Permissible zones often change depending on the type of use. For example, some cities may allow storefront retail facilities closer to residential areas, whereas you can virtually guaranty that volatile manufacturing will be stuck in industrial zones.
• States and cities also impose all kinds of location-specific restrictions. Cannabis businesses, for example, may be prohibited within X feet of schools, parks, churches, libraries, etc. In places like California, cities often add restrictions on top of state-specific requirements.
• States or cities may also impose limitations on the number of cannabis businesses that can be located in a specific area. Sometimes we see caps on licenses within a city (more on that later), whereas some cities will instead prohibit two different cannabis businesses from existing within a certain distance from each other.
• In addition to location-specific issues, there may be a host of property-specific issues that could disqualify a potential property. A piece of real estate may be properly zoned and outside buffer zones, but may not comply with local parking requirements, setback requirements, electricity needs, and so on.

Each of the issues above can be automatic disqualifiers for a parcel of real estate. Things like buffer zone locations can be difficult to figure out and change over time. For example, a school might open up in an area before a cannabis business submits a license application, and it may lose out on its chance to do so. All of this is to say that performing diligence on a property and its location is absolutely critical prior to entering into a lease or committing to purchase a piece of real estate.

Buying v. leasing?

When a cannabis company finds a good piece of property in a good location, the next most important decision it needs to make is whether to buy it or lease it. There are some key exceptions here, like large farms or processing facilities in industrial or agricultural areas. But in general, most cannabis companies tend to lease. There are a lot of reasons why cannabis companies opt to lease real estate instead of buying. I discussed that in detail here. But generally speaking:

• Cannabis companies are startups with limited funds that opt to lease, rather than buy.
• Buying real estate is usually much more complicated than leasing it.
• Businesses don’t want to commit to a multi-million dollar purchase before knowing they can secure a license and/or have any prospect of success.
• Financing is a big challenge! That brings me to the next point.

Financing, escrow, and title

Securing financing has long been a challenge for cannabis companies. In fact, my last post analyzed key issues that cannabis companies can expect when trying to secure financing. Few startup cannabis companies are sufficiently capitalized to purchase real estate without financing, and because traditional financing is almost never available, buyers usually end up with much higher interest rates and more lender-friendly terms.

But buyers are not the only ones that have to deal with financing-related issues. If a cannabis company wants to lease a piece of property that is subject to a mortgage, it will probably not happen. Big banks do not usually bank cannabis money, and usually will have the ability to default their borrower (the landlord) for leasing to a cannabis company. I’ve seen a lot of potential real estate leases fail for this reason alone.

Another difficulty here is getting escrow companies or title insurance companies to work on cannabis real estate transactions. Like bigger banks, many of them simply won’t do touch cannabis transaction. This is especially so in jurisdictions when they commence licensing.

Addressing licensing uncertainty in cannabis real estate deals

There is no way a cannabis company can guarantee that it will secure a license. Even in non-competitive jurisdictions, there are a host of potential property- or location-specific issues that could bar a license application. The chance of losing out is much, much higher in a city with 3 licenses up for grabs and 30 different applicants. I recently wrote about some key issues for competitive licensing jurisdictions and real estate leases here.

Of course, there are ways to hedge against these kinds of uncertainty. Here are a few I’ve seen:

• Non-binding letters of intent or term sheets may be acceptable to some cities, but they obviously come with the risk that the lessor could walk away or change key terms if the agreement is not binding.
• Options to lease or purchase upon securing a license, as opposed to full-scale leases or purchase agreements, can be a good way to tie up a piece of property while waiting for a license to issue.
• Leases with termination rights if a license is not secured are yet another way to hedge against denial of an application.

It’s key to point out that licensing authorities may have strict requirements on what a tenant needs to show in order to apply. Some cities will not allow a document unless it is binding (i.e., an option or a full-fledged lease). This is yet another reason why early diligence is so key.

Other issues for cannabis real estate transactions

Some other key issues that I’ve seen come up more than once include the following:

• I have never seen a cannabis applicant that did not construct at least some tenant improvements to their facility in order to get licensed. Tenant improvements can lead to increases in real property taxes. It’s best practice to address who is responsible for those improvements in a lease.
• Going off the last point, I’ve seen quite a few cannabis tenants turn a dilapidated building in an industrial area into a highly productive, state-of-the-art facility. As you can imagine, this costs a lot of money. Savvy tenants may try to negotiate some kind of tenant improvement allowance from the landlord. Or they may use their improvements to justify lower rent or a longer lease term.
• Form commercial real estate leases universally require tenants to comply with all laws. It’s good practice to carve out federal cannabis laws. Not only will this avoid a default trap, but it will also prevent a landlord from trying to later terminate a lease with the claim that they were unaware that cannabis was federally illegal (yes, I’ve seen things like that happen).
• Renewal options are key! Cannabis leases tend to hover around five year initial terms. In states like California where licenses are effectively tied to a single piece of real estate forever, landlords have immense power to walk away from the lease at the end of the lease term unless a tenant has renewal options (and timely exercises them). This obviously would be devastating for an applicant who couldn’t move its license elsewhere.
• Purchase options are also important. Cannabis lease rent tends to be much higher than market rent for similar non-cannabis uses. And it almost always increases year over year. Businesses with multi-year lease terms may want a purchase option so that they can determine whether it makes more sense to buy the property outright (if doing very well) as opposed to paying X times market rate each month.

I could keep going here for a long time. The point is that real estate deals in the cannabis space are difficult and are riddled with potential pitfalls. Using a form lease from a normal commercial transaction is almost always a bad idea, and failing to properly diligence real estate can lead to repercussions.