From SoCal Real Estate’s November 2018 issue:
By Michael Dorsey, SVP, partner, Kidder Mathews
The recent legalization of both medical and recreational marijuana in California, among other states, has created a new market within commercial real estate brokerage. It is one of the fastest-growing niches in the industry, but due to legal uncertainties on the federal level, it has proven to be quite challenging from both a transactional and capital-markets perspective.
First, it is important to understand that on the federal level, marijuana is still classified as a “Schedule 1 Drug.” Essentially, that places it in the same category as other strongly addictive drugs. Therein lies the problem as it relates to the legalization on a state vs. federal level. Because marijuana is classified by the federal government as a Schedule 1 drug, federally insured financial institutions are prohibited from processing and/or accepting cash from any cannabis-related transaction. To do so would be against federal law and would be in violation of federal “money laundering” laws. As a result, the traditional capital-lending markets have been stymied from lending in this industry. For the time being, given the restriction on traditional capital-lending sources, the gap has been filled inefficiently by various “hard money” non-bank lenders and various private-equity investors.
However, the solution to this capital-markets lending conundrum could soon be on its way. Recently, the state Senate passed a bill to create a state charter for banks and credit unions that would provide the ability for licensed cannabis-related companies to write checks, deposit cash, and pay taxes and fees to vendors. Among the obvious banking reasons, supporters also feel the bill would add a much-needed security and safety feature that has been lacking in the industry due to its current “all cash” operational status. Needless to say, the bill known as SB–930 and authored by state Sen. Robert Hertzberg, D-Van Nuys is being closely watched as it heads to the Assembly.
From a brokerage standpoint, given the existing “all cash” nature of this industry and the relative dearth of supportable financial statements, how does this affect the “non-traditional” complexities of lease negotiations as they relate to structure, securitization, and tenant improvements?
When negotiating a lease, it is important to prepare your cannabis tenants with certain financial hurdles that will be mandatory to making any deal. First, in the absence of supportable financial information, the tenant will be required to pay first month’s rent, a meaningful security deposit (three to six months’ rent is not uncommon), and a certain amount of prepaid rent, which will be staggered over the term of, say, a five- to seven-year lease. The prepaid rent will be credited on specific designated months as the lease seasons. This creates a financial security component for the landlord in the event the tenant should stop paying rent for some reason and default on the lease. In addition, if it can be determined that the tenant has other personal assets, a “personal guarantee” should be requested to add an additional layer of financial securitization for the landlord.
It is also important to note that generally, any and all tenant improvement work (above BOMA shell standards) would be a tenant-related cost. In addition, tenants are required to pay for all costs associated with acquiring all local and state licenses, permits, and related fees for conducting their business.
I would be remiss if I didn’t mention “lease contingencies” relative to the tenant receiving a “cancellation right” in the event they are unsuccessful in receiving required approvals, licenses, permits, etc., to conduct their business. Typically, the deals I negotiate will have a reasonable contingency window for the tenant to process their conditional-use permit (CUP) — usually three to four months. During this time, the tenant will be obligated to pay half rent and will be given the opportunity at the end of the 120-day period to either cancel the lease or waive the cancellation contingency, at which time the lease would continue in full force and effect.
It is important to note that the negotiated “contingency period” is not tied to the issuance of the CUP or any other required approvals, but rather just a stipulated courtesy time period granted to the tenant in which they are required to render an “opt in” or “opt out” at the designated time. Generally, even if tenants do not have all of their required approvals, they do not “opt-out” because by that time they are significantly invested in the process and have relative assurances that their approvals will be granted.