No matter your personal feelings on the subject of cannabis, the reality is that it is at the heart of an ever increasing number of businesses and entrepreneurial ventures including real estate. Despite remaining illegal on a federal level, the changing of many state laws over recent years has led to an increasing number of businesses centered around cannabis. Perhaps you have come across opportunities to invest in cannabis-based businesses or thought about leasing land or property to a cannabis related operation, but what do you need to be aware of to venture into the space? As it turns out, you need to know quite a bit. If you want to stand a chance of not getting in legal or financial trouble, you need to do your homework before jumping in.
I was fortunate enough to have recently been able to attend the Intelligent Investor Real Estate Conference which I would highly recommend being on the lookout for next year as it was a very well put-together conference with great value. Looking back on some of the notes I jotted down from the presentations, I realized I had taken more notes on the “Cannabis and Real Estate” panel presentation than any other that weekend. It was very insightful and I figured some of what I learned might be useful in educating other real estate investors that perhaps might already have evaluated some investing opportunities in this niche or are bound to come across some in the future. With that in mind, I thought I’d share some of the highlights that seemed relevant to be aware of when considering this sector.
Due to the still evolving laws and regulations in this industry, financing of businesses associated with cannabis in any way have fewer financing options and generally less favorable terms in what is available. At this point, financing terms are relatively short in nature with 2-3 years being about as far out as lenders want to commit. In this regard, if you are looking at investing in either a cannabis-based business or a real estate investment leasing to a cannabis-based business, bear in mind that if financing is part of the business plan or pro forma that you should also be looking a year or two out to see how that investment would do if the same financing is not available or has substantially changed.
In addition to the shorter lending timeframes, since cannabis remains federally illegal, banking options are limited as banks do not want to run into problems with violations of federal law as could occur if handling the proceeds of businesses within the cannabis industry. For this reason, much of the finances associated with cannabis-related businesses are handled exclusively in cash which is fraught with many issues of its own.
CAPITAL INTENSIVE NATURE
Many businesses within the cannabis industry, especially those related to growing, can be very capital intensive. If you are leasing to a cannabis business, part of your due diligence should include verifying that the business plan of the lessee reflects sufficient capital and a strategy to cover the expected AND unexpected capital needs of the business that will be necessary to make the business successful. If the business is skimping in those areas to make the financials work on paper, this is not a good sign and does not bode well for the success of their business. Basically, screen your tenants in the context of the business as you would with any other rental. Just as renting a residential housing unit to a resident without proper screening can cause you significant headache on the back end, so too can leasing to a business lessee that is not properly screened for a well thought out business strategy and availability of capital.
If it is a passive investment you are looking to make in a real estate ventured involved in leasing to a cannabis-related business, it’s also important to have a sponsor that is as experienced as possible in this niche to be well versed in the nuances and peculiarities of the industry. It could even be argued that it is even more important in this sector to have a sponsor that has strong financials personally as well. Although in theory the sponsor would not be obligated to use their own funds to support/float a business, the ability and integrity to do so could be critical in some situations in this sector. So, choose your sponsors wisely in this space.
If you are leasing property to a cannabis-related business, make sure both your insurance policy and the insurance coverage of any business you are leasing to does not have gaps in coverage that could expose you to industry-specific liabilities that could arise. Events such as electrical mishaps, explosions, fires, etc. can and do sometimes occur and you need to make sure both you and your lessee are sufficiently covered.
The permit of a property to operate a cannabis based business is attached to the facility not the operating company, so this license can significantly increase the value of a property. Because of this, valuation of such properties can deviate significantly from usual property values and can be quite irrational. Likewise, market rents for such properties can be as much as 2-3X average market rents.
Some states have a limited number of licenses to distribute to facilities tied to the cannabis industry, so that can impact supply and demand in any given area. For example, CA and CO have unlimited number of licenses to distribute but other states are limited. Therefore, make sure you are aware of the availability of a permit if you are basing a business plan or pro forma on the facility being able to obtain a permit.
GENERAL LEASING CONSIDERATIONS
Triple net (NNN) leasing structures are pretty much the standard for leases on facilities leased for cannabis related businesses. As such, be aware the build-out for such facilities can be expensive secondary to the extensive infrastructure required for such operations: electrical, HVAC, and climate control can all be significant considerations for success. Consider what you are planning or willing to equip your facility with and how that aligns with the operations of the business lessee you hope to attract.
EXPECTED RETURNS IN THE SPACE
Due to uncertainty in the space, the general consensus among conference attendees was that participation as a passive investor in any debt deals related to cannabis real estate should probably be returning a minimum of 9% per annum but more likely closer to 12% per annum to make the risk worthwhile. Keep that in mind so you realize your risk in investing in this industry should not be underestimated and you should be getting a relatively high return for these investments.
In summary, this sector of business and real estate is very dynamic and uncertain at this point with regulations changing rapidly. Like most things, there is potential reward and potential risk, both which are ill-defined at this time. What IS clear though is that if you are going to invest in this sector you must be prepared for potential unknowns.
Have you invested in a cannabis-related real estate venture? If so, I'd love to hear your comments or experience and any additional words of wisdom about the sector.
Good luck out there and happy investing!