The cannabis industry had a banner year in 2018, and the success has continued unabated into 2019.
Last week, New York Gov. Andrew Cuomo signed a bill decriminalizing recreational marijuana. In June, Illinois Gov. J.B. Pritzker made his state the first to approve the legalization of recreational marijuana via the legislature (as opposed to referendum). The sale of cannabis in Illinois will begin Jan. 1, 2020. That same month, the U.S. House of Representatives approved a measure that will keep the federal government from interfering with state laws regulating marijuana use.
It’s becoming more difficult to imagine the tide turning against full-scale legalization. And, for investors and lenders, direct investment in the real estate behind a cannabis business can be the most attractive aspect of an investment, a quick and seemingly safe way to penetrate the roughly $60 billion industry.
For cannabis businesses, everything starts with commercial property. It’s the lifeblood. Businesses and upstart entrepreneurs are required to show proof of right to real property prior to even being considered for a U.S. state license to operate — finite opportunities that are in no way guaranteed.
“As far as investment goes, real estate is extremely popular,” said Hilary Bricken, a cannabis and corporate law attorney at Los Angeles-based firm Harris-Bricken. “The asset is going to appreciate, probably, in the long run anyway, and you can always turn it into something else and lease it out again in most of these major metropolitan areas.”
That seems nice, except for the unfortunate facts that tenants can still be prosecuted under federal law and landlords can still lose property to federal forfeiture; and investors can be pursued for secondary criminal liability for aiding and abetting and conspiracy; and lenders risk action under the Bank Secrecy Act and can be hit with fines and penalties from the Treasury Department and can also be accused of laundering what’s still essentially considered drug money.
This mostly keeps banks and traditional financing institutions away from funding anything involving the actual plant, an area of the legal industry that grew to $10 billion last year and employed around a quarter of a million people, according to figures from cannabis research and analytics firm New Frontier Data.
As a result, alternative lenders, hard money lenders and ambitious investors sit atop the mountain.
“The thing that financial institutions will do is they also play in the ancillary space,” Bricken said. “They will finance and bank technology around cannabis or equipment around cannabis or hardware. That’s one way they participate indirectly without completely and totally violating the Bank Secrecy Act.”
Notwithstanding, investors injected about $10 billion into the North American market last year, doubling the total invested in the previous three years combined, according to New Frontier Data; that number is expected to balloon to $16 billion this year.
So far, 11 states and the District of Columbia have legalized the sale and recreational use of cannabis, while another 15 states have passed measures to decriminalize the substance — two-thirds of states currently allow for medicinal sale and use.
States determine who gets cannabis licenses and when and for what purposes, and the laws and requirements differ state to state and product to product, depending on the type of operation.
State legislatures are seeing the money, and they want in, as do major financiers, who want the peace of mind of being able to freely lend and invest without federal intervention.
But, with legalization — be it recreational or medicinal — comes a bevy of fresh tax and legal hurdles and other financial obligations from each state which need to be satisfied in order to obtain and maintain a license to operate. For cannabis businesses navigating a young and wild industry rampant with fraud and a lack of monetary assistance, many are gasping for air.
The engrained legal differences in each state and the illegality of transporting product across state lines adds to the troubles. “Every state is its own country,” said Richard Acosta, the CEO of cannabis real estate investor and lender Inception REIT.
“It’s not all blue skies and flowers,” Acosta continued. “There’s a lot of ugly still out there: the black market, the taxation, the competition. And I think a lot of folks are going to end up hurt.”
He said eager hard-money lenders are subject to stepping in and possibly “mis-pricing risk and not quite understanding how to get out of 24-month financings … there are one-off family offices, where someone knocks on their door and they find this interesting, differentiated and unique. There’s no organized competition.”
The U.S. Controlled Substances Act prohibits manufacturing, distributing, dispensing or possessing cannabis and its extracts. The plant itself is still classified as a “Schedule I” narcotic, meaning that the government officially considers it a dangerous substance devoid of medicinal qualities and most likely to lead to abuse and dependency. It’s lumped in with the likes of substances such as LSD, ecstasy, and even heroin.
This creates a rather significant financing hurdle.
“In March of last year, there were maybe a little more than 300 financial institutions participating, which is incredibly tiny,” Bricken said. “Even regional banks are subject to federal law; the Bank Secrecy Act (BSA) applies across the board, even if you are a regional bank. Plus, you have to get insurance from the FDIC and you cannot violate the BSA and get that insurance. Tribal banking is in there as well, even though they are their own sovereign, it doesn’t matter.”
Bricken said that to be successful today, a cannabis operator must have a track record and be well capitalized, which she said is ironic given the lack of financing sources currently available.
Acosta said that Inception REIT takes a three-pronged approach to underwriting for investing or lending. “It’s [about the] real estate first and then credit and operational underwriting and then ultimately it’s structuring the right deal,” he said.
Cannabis real estate assets can fall into the categories of industrial and logistical, as well as medical, health care or retail. For the most part, every type of cannabis operation is labor intensive and expensive to run.
The most daunting is the cultivation of the plant, which is the first step in the supply chain. A good operation produces three or four grow cycles per year, from the seed to the trimming of the leaves, Acosta said. It’s a very “intense” process in nearly every respect, from energy and water use to manual labor.
“That’s our least favorite place to be on the hard asset side, because no one has found a way around the laws of supply and demand,” Acosta said. “There’s just more and more cannabis being grown in the U.S., and specifically, in California, it’s up to the cities to create caps and programs around licensing.”
Acosta said investors who are engaging in sale-leasebacks and acquisitions of cultivation assets are “getting great returns, around 14 to 15 percent unlevered deals. But, the challenge with that model is that the real estate fundamentals are clearly stretched. And second, residual value is pretty much nonexistent because they’re capitalizing the value of tenant improvements and not the value of the land and the warm shell.”
And, with that, licensing caps, operational and zoning restrictions and miles of bureaucracy stand in the way of the production and delivery of product, which affects bottom lines.
“You can freely move product from Northern California to Southern California and vice versa, but there’s only one direction the price per pound is going and that’s down,” Acosta said. “So, that squeezes operating margins and squeezes implied coverage metrics on rent or debt service, depending on the structure of the deal.”
Taxes are a primary burden for cannabis tenants, specifically the onerous Section 280E provisions, which say that a business engaging in the trafficking of Schedule I (cannabis) or Schedule II controlled substances are barred from claiming tax deductions or credits.
“[280E] doesn’t allow market participants to deduct anything beyond cogs,” Acosta said. “For cultivators, if you think about their business and how much labor goes into that, the cogs for a cultivator are literally just seeds.”
He said retail tenants are better off on that front because they’re buying product wholesale.
“A lot of these growers, distributors and retailers are getting crushed because their effective tax rates are 50 to 60 percent [or more],” Acosta said. “That [alone] is propping up the black market, because it allows it to easily compete with the above-board market because they don’t pay taxes” and are therefore able to offer cheaper products.
Acosta said it’s common for cannabis businesses and tenants to feel backed into a corner by taxes, fees and regulations, meaning the odds increase that they’re going to be incentivized to tap into an unregulated black market to dodge steep taxes and fetch returns for a portion of their product.
That exposes the tenant and their investment partners and bankers to criminal liability and potentially significant losses, said attorney Hilary Bricken.
Acosta estimated that about 80 percent of all marijuana sales in California — the country’s largest market — still go through the black market. In 2016, of the over $50 billion in marijuana sales in the U.S., about 87 percent was black market, according to a report from cannabis research firm Arcview Market Research.
“The challenges are significant, the black market is real, and it certainly pressures our tenants’ businesses,” he said. “We’re tracking enforcement in the larger markets we’re in and we’re tracking trends of licenses, which, like gaming, means with more licenses means more competition and more pressure on the economics. This is where a hard-money lender comes in and doesn’t understand the dynamic. Oversupply is real on the cultivation side, which is why we stay away from those assets. There’s an ugly underbelly to the industry.”
Fraud, which is to be expected in a young industry, is also a chief concern for most real estate players. One cannabis investor told CO that he’s seen a scam in which fraudulent armored car services that look legitimate trick retailers into allowing them to pick up and transport cash to their bank. It disappears.
Major federally chartered banks “do not want their collateral put into jeopardy with the federal government because of asset forfeiture,” Bricken said. She said if a large bank “uncovers that a landlord customer is putting the collateral in jeopardy by leasing to a cannabis business, it violates the mortgage and lending [agreements]. So, they [can] call down on those contracts in the face of those violations and the landlord has no leg to stand on.”
The financing dilemma has forced many operators into considering purchasing their own real estate, but “there’s a lot of inflation in asset values and a lot of excitement around the industry and that tends to permeate to hard assets as well,” Acosta said.
That’s where smaller regional banks and rough and tumble alternative lenders and other, more institutional debt providers such as cannabis REITs really carve out their space.
Acosta’s Inception REIT is a cannabis lending and investment arm of Inception Companies that targets real estate lending and investment opportunities supporting cannabis owners and operators who are “in the center of the supply chain,” according to Acosta. He said that from a risk perspective, this is the most attractive debt investment for the shop.
The center of the supply chain is a more predictable and less volatile area that includes manufacturing and extracting concentrates from the actual flower to be used in edibles, oils, topical creams and the like.
“In the middle of the supply chain, you’re extracting the raw flower into oil, you’re manufacturing joints, or pre-rolls, and it’s a value-add product,” he said. “We like that, and we think it’s brand-dependent, so we have a good understanding of who’s who, making bets on who will survive the eventual onslaught of consolidation.”
The company’s current portfolio is concentrated in California and Arizona, and it’s in contract on a large multi-tenant industrial asset in Oregon, Acosta said.
“We get inbound requests daily, without exaggeration, from newer markets trying to finalize recreational programs, like Massachusetts, Michigan and Florida,” Acosta said. “From an industry perspective, there’s just a little too much risk. You can underwrite real estate there, but you’ve got to get the operational underwriting correct.”
Still, when it comes to traditional banking, regional outposts don’t have a marijuana leaf stamped on their foreheads. Third-party services are used as “go betweens” to FDIC insured banks, circumventing a direct lending approach by tackling the vetting processes ahead of any business accounts being opened.
Other services, like PayQwick, partner with cannabis businesses across the supply chain to provide a range of electronic payment and compliance solutions as well as armored car pick up services.
The lack of financial support and clear regulatory direction for the cannabis industry has forced many real estate professionals to take matters into their own hands to simplify the processes for businesses and get them up and running in the properties they need.
Canna-Hub CEO Tim McGraw (no, not the famous country music star) has taken up the task in rural California of providing a full suite of cannabis-geared real estate to operators.
McGraw has 21 years of real estate industry experience and has spent six years in regulated cannabis operations. He started in cannabis in Illinois. “If you can make it there, you can make it anywhere,” he said, referring to its historically stringent cannabis laws and regulations.
His firm does the legwork for licensed operators, securing entitlements and zoning, judicial use permits and development agreements. He then constructs built-to-suit cannabis coworking-like gated business parks — protected by trained armed guards, whom he interviews and vets individually — in rural California communities for said operators to lease out.
“Real estate is the nice, safe play; we’re never worth zero,” McGraw said. “The risk is spread out over dozens of operators so you’re not betting on a single guy.”
The company’s main campuses are located outside of Sacramento — the 1.2-million-square-foot Williams Campus — and Fresno — the Mendota Campus. Each comprise dozens of buildings and can host a range of tenants, except outdoor cultivation and retail.
“Hands down the large-scale cultivation is the most difficult thing to do in the business,” McGraw said. “[But in] Williams, when we kick that off, we expect to have around 100,000 square feet of greenhouse in phase one, and we’re adding 100,000 square feet of greenhouse at Mendota. There’s not a huge demand for indoor grow, and frankly, I don’t mind not taking that risk. That’s the most capital intensive and risk heavy side of the business. It takes the longest to start making money.”
McGraw’s experiences spurred him to build a concept that aims to make it as easy as possible for businesses to thrive.
“There’s a lot more that goes into these projects than a standard infrastructure,” McGraw said, adding that he charges standard rates of $2.50 to $3 per square foot, triple net. “[We provide] tax savings. Because you’re located in one of our campuses, you’re now not paying an average of 7.6 percent of your gross revenue to the city. We incorporate logistics, site infrastructure and local politics, it all melds together into a formula. It’s called doing your due diligence, and I do a lot of it.”
McGraw finances his “Canna-Hubs” with regional bank dollars, and although he wouldn’t disclose the names of the institutions, he said the relationships are a product of his deep background in real estate and cannabis.
He said the door is wide open for regional banks to lend into cannabis but that “it’s just an operational headache for them on the audit side, having a cannabis operator. They have to audit and require a full accounting of every transaction over $500. And if you’re touching the plant, and using a state bank, they have a microscope on you — and they charge higher account fees.”
But investing and lending into the cannabis space is only getting hotter, meaning the need for clear directives for businesses and investors is paramount. The United States Marijuana Index has grown a whopping 142 percent in the last three years, as of July 31. And the Canadian Marijuana Index has grown a staggering 338 percent over the same period. Even the former U.S. Speaker of the House, John Boehner, sits on the board of Acreage Holdings, a U.S. cannabis investment firm.
The expansion has increased the speed of innovation and level of competition and thus, consolidation. Some real estate companies are tapping into the industry to explore ways to incorporate cannabis retail into shopping centers.
CBD company Green Growth Brands (GGB) has caught the eye of such prominent real estate players as mall behemoth Simon Property Group, which partnered with the company in February to open around 108 GGB stores at its locations.
Cannabis retailers — at the very end of the supply chain — can sometimes find it harder to secure real estate and get licensing, depending on the type of business and the state in which it operates. Many localities push back against them as public safety hazards prone to burglary and theft, just given the fact that many are cash businesses and typically have a lot on hand; the shops can also drive a lot of traffic and even tourism.
There’s also a risk that retailers could be dealing product “out the back door,” Bricken said, which could put every party involved or invested in the business at risk.
“The dispensary is one that is seen, the brick-and-mortar, and you know what it is … [it’s] out there, loud and proud; they want to have and provide good retail experiences, so they have a lot of windows and there’s a lot of cash on site from daily transactions, so they are probably the ones that receive the most scrutiny.” Bricken said.
But in no way has that scared landlords away from considering the monetary and economic benefits of leasing to cannabis.
James Savard, executive vice president in leasing and management at Metro Commercial, said that while medical marijuana isn’t technically a permissible use under most leases, “a few years ago, we started recommending to our clients that they change the language; that if it is legal in a state, then it was sort of accepted from the exclusion of a shopping center.”
“When we started evaluating the market, we saw what Simon [Property Group] was doing with CBD. You’ll see it with the organic and natural grocers, like Sprouts [Farmer’s Market] and Whole Foods; they’re selling CBD products,” Savard said. “Everyone seems to be jumping on the bandwagon. It boils down to the fact that CBD and medical marijuana [professionals] are building these beautiful stores, like MedMen and its Fifth Avenue [location in Manhattan].”
Metro Commercial represents a range of landlords, advising local investors to developers to major REITs, operating in Delaware, New Jersey and Pennsylvania — all states that allow for medicinal sale and use.
“In states where it’s fully legal, people understand what the industry is, so they have a much clearer picture and understanding of whether it can be suitably used in a shopping center,” Savard said. He added that cannabis could be a key in helping kickstart the brick-and-mortar retail experience that’s slowed in the face of a digital landscape.
“I think it creates a real opportunity for brick-and-mortar guys,” Savard said. “It’s not just about the pot you smoke; it’s the cannabis cafes; it’s the food products and the edibles and the oils and creams and all the other functions it serves. I’m actually curious to see how the cannabis-related food products will take off.”
The seeds of interest never stop growing.
“The industry is shifting daily,” Acosta said. “There are developments, whether it’s regulatory or on the research and development side or licensing. From a risk underwriting and risk management perspective, we’re sticking to more established legacy markets.”
The space is starved of cash only because traditional institutional financiers have their hands tied behind their backs, stalled by the fact that there is no direct work-around to the idea that a bank can’t lend on a property conducting “illegal activities.”
Nonetheless, large banks have been hard at work trying to find a way to tap into the nearly $60 billion market.
A couple of weeks ago, participants in both the banking and cannabis industries appeared before the Senate Banking Committee to lobby for access to the U.S. financial system. The hearing centered around the SAFE Banking Act, which was first introduced to Congress in 2017 and would bar banking regulators from intervening in the actions of a financial institution working with cannabis businesses in states where the substance is legal.
Earlier this year, it was reported that Citigroup, the fourth-largest bank in the U.S., has had internal discussions on how to enter the fray and provide services to those in the space.
“The bank prohibition will be over soon and that’s going to open up the capital markets big time,” said Canna-Hub CEO McGraw. “Pension funds and everybody that’s stayed away — the institutional money — now will have no excuse not to [be involved]. It’ll happen, and it’ll be explosive — 2020 will be a crazy year.”