Cannabis Net Lease Offers Potentially High Risk to Landlords

The moment states began making cannabis product sales legal in varying degrees, the dollar signs popped up in the eyes of investors, financiers, and also CRE property owners. High demand products with strong pricing and limited access seemed like a dream.

Except, legal and regulatory snafus and limitations on the businesses meant a lot less profitability. Landlords who might appreciate premium pricing, along with offloading tax, maintenance, and other expenses need to put some significant effort into potential tenant relationships to stay out of trouble.

First, know whether you can lease the space to that type of business. “Where it starts is state law,” David Waxman, of counsel at McGlinchey Stafford, tells GlobeSt.com. “Typically, in a statute or regulations, there are a certain number of dispensaries to be had in one area.” Cities or towns might be limited in what they can do or allowed to completely opt out. A combination of state and local regulations might specify setback requirements and spacing from schools or places of worship, which can limit eligible properties.

One hurdle for many landlords would be the federally illegal nature of the businesses, as marijuana remains a Schedule-1 controlled substance. That means any loan covenant that requires tenant businesses to remain within the law could call the property financing into question and potential cancellation.

“Because interest rates have often gone up since the mortgage was obtained, a lot of landlords don’t want to refinance,” Michael Rosenblum, a partner and cannabis chair at Thompson Coburn, as well as former general counsel for large cannabis operator STIIIZY, tells GlobeSt.com. “A lot of times the deal fell through because the landlord wasn’t allowed to rent to cannabis under loan documents.”

“We’ve heard story after story of landlords, both small and very large, at the risk of losing their credit facilities if they allowed the proposed tenant to open shop,” says Anthony Coniglio, chief executive officer of NewLake Capital Partners. The firm provides sale-leaseback capital to cannabis-related companies that may not qualify for traditional financing. As a result, it owns 17 dispensaries and 14 cultivation facilities across the country.

The tenants might have specific needs, like extended parking or specialized HVAC equipment to handle indoor smoking. This is often on the landlord because tenants can’t get traditional financing.

There are also the costs for banking, which requires paying extra to the banks that have to cover significant regulatory compliance costs. Rachel Xin, who is in real estate, has an MBA, and is cofounder of premium Costa Mesa, California cannabis retail store High Seas, says she sees fees ranging from $600 to $1000 a month.

The landlord could ask for more in rent, but that assumes plenty of pot profit to go around. Such is often not the case. Cost of goods are high and higher, depending on location. Coniglio says that cannabis is under $1,000 a pound in California but can hit $3,000 in Connecticut.

“With every market, as it matures, pricing compresses,” Coniglio says. “Can they withstand the price compression that will occur in that market?” Don’t look at a tenant’s margin in early days and assume that they represent the future.

On top of that, IRS regulations forbid the deduction from taxes of ordinary operating expenses unless directly tied to cost of goods. That means treating significant portions of gross revenue as profit, driving down a company’s net and, therefore, ability to pay rent.

Initially, many landlords got rent premiums — maybe 50% to 100% extra over going rates — thinking them a form of protection, Rosenblum says. The comfort didn’t last long because the large upcharges increased the financial pressure. “Most of them looking back on it I think regretted it,” he says. “They would have been better off charging 110% and gotten a higher quality of tenant, because so many of the cannabis companies ended up going under.”

The shop owners face many challenges. In some states the license process can take years according to Xin. “You have to be able to put a lot of money into the business,” she says. She separately owns the property leasing to High Seas, and she can ensure that the rent is reasonable, looking to the cannabis business as one for the long term.

There is frequently high density of cannabis shops, increasing competition and pushing down margins, making success even harder. “That’s why I’m not doing as a landlord doing business with other cannabis operators,” Xin says. “I would not play a strategy for a portfolio of the real estate. I could make a lot more in the other [retail] segments.”

And there’s frequently a lack of needed business acumen on the part of the stores. “I already know which of our competitors are not going to make it,” Xin says. “I think only 3 to 5 will make it through and be financially sustainable. Some of them are struggling, some of them are not paying their vendors or landlords.”

Which comes around to the final advice from everyone who spoke to GlobeSt.com. Perform heavy due diligence to be sure that a cannabis dealer has the resources and business wherewithal to eventually succeed and contractually require them to provide key information, like ongoing license compliance, so you’re not taken by surprise.