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Legalization and Cannabis CRE Investments

August 5, 2021
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On July 14, Senate Majority Leader Chuck Schumer (D-NY), Sen. Cory Booker (D-NJ), and Sen. Ron Wyden (D-OR) introduced a preliminary draft of the Cannabis Administration and Opportunity Act, the new Senate bill that would, in fact, legalize cannabis at the federal level in this manner:

  • Cannabis would be removed as dangerous and addictive Schedule I substance from the Controlled Substances Act.
  • States rights would be recognized to the extent that individual states would still be able to enforce their own cannabis regulations.
  • The cases of those arrested and convicted of non-violent cannabis crimes would be expunged from federal records.
  • As you would expect, a regulatory framework is proposed for a federal cannabis tax structure.
  • The establishment of a grants program to fund nonprofits that help correct social inequities as a result of the “War on Drugs.’

The price the industry would pay. Written into the Act is the potential of a 25% federal excise tax imposed on cannabis sales on top of tax rates already in place at the state and local levels. Senator Schumer acknowledged that this draft legislation does not have the votes to pass at the present time. And it is doubtful that President Biden would sign this major cannabis reform.  Nevertheless, it is the latest example of the pace of federal legalization of cannabis picking up.

On May 28, 2021, Rep. Jerrold Nadler (D-NY) reintroduced the Marijuana Opportunity, Reinvestment and Expungement (MORE) Act in the House of Representatives. The House voted in favor of this Act in a 228-164 vote in December 2020.  It is the version of removing cannabis from the Controlled Substances Act that the House has initiated.

Just prior to that in May, Republican Reps. David Joyce (OH) and Don Young (AK) introduced the Common Sense Cannabis Reform for Veterans, Small Businesses, and Medical Professionals Act. This bill also addresses the federal legalization of cannabis.

Prior to that in April, the Secure and Fair Enforcement (SAFE) Banking Act was approved by the House in a bipartisan vote of 321-101. The SAFE Act, which would enable financial institutions to provide banking services to cannabis businesses that are legal in their respective states, was also previously passed by the House in 2019. It now goes to the Senate for deliberation.

This accelerating pace of national legislative attention to the cannabis issue appears to be a question now of not “if” federal legalization will occur, but “when.”

Exponential Industry Growth

The majority of the U.S. population now resides in states where cannabis is legalized in some form. 37 states, the District of Columbia, Guam, Puerto Rico, the Northern Mariana Islands, and the U.S. Virgin Islands allow for comprehensive public medical marijuana programs. 18 of those states and DC have approved cannabis for legal adult consumption. Last week the industry data research and analytics firm, Headset, forecast that the U.S. legal cannabis market will surpass $30 billion in sales as early as next year.  A Pew Research Center Poll released in April found that 91% of U.S. adults favor marijuana being made legal for medical and recreational use. And the Wall Street Journal reports that Q1 ‘21 cannabis sales in Illinois and Florida compared to 2020 have increased between 90% and 100%, with total sales of recreational marijuana in the U.S. having increased from $13 billion in 2019 to $20 billion in 2020.

(NAR) entitled Marijuana and Real Estate: A Budding Issue that there is a marked increase in demand among their commercial members for warehouses, land and store fronts used for marijuana production and sales. The report states that although there are a number of reasons why commercial real estate inventory is tight in their areas, one-third of their respondents in legal marijuana states report that the marijuana industry is contributing to this condition. 29% of commercial members in legal states report that during the past four years there is a significant growth in property purchases as opposed to leasing.

Factors Favoring Legalization

While there are a number of compelling factors favoring legalization at the federal level, this is simply another case of follow-the-money – of the potential of free-flowing tax revenue, that is, as the federal government examines ways to profit from legalization. The irony is that this revenue factor, above all others, is the element that literally guarantees legalization. As is done with cigarettes and alcohol, legalized cannabis will be heavily regulated and taxed. For one example of the tax revenue bonanza is what the Colorado Sun reports about tax revenues in that state since legalization.  Since legalization in the state in 2014, marijuana sales have topped $10 billion.  Tax and fee revenue realized by the state have exceeded $1.63 billion to date.

On a less cynical note, however, there are gross market inefficiencies that federal legalization would cure.  Internal Revenue Code Section 280E, for one, has been precluding cannabis businesses from realizing federal tax deductions and credits because of the Schedule I classification of cannabis.  This forces cannabis businesses to pay a far greater share of net income as taxes, compared traditional businesses. The prohibitions against banks dealing with cannabis businesses has compounded many problems the cannabis industry faces.  The industry has been severely capital-constrained until the advent of M&A transactions and debt funding have provided the industry’s cash resource. Private investors have also been dissuaded from entering an industry where access to bankruptcy protections is completely unavailable as long as cannabis businesses operate in a Schedule I industry.

Another disadvantage the cannabis industry is struggling through is the lack of intellectual property (IP) protection. Because the IP and trademarks of cannabis firms fall outside the protections of the Lanham Act, brands, recipes, extraction and manufacturing processes are all susceptible to infringement.

Federal Legalization vs. the Localized Cannabis Industry

However, there are dissenters out there who would argue on the side of leaving the regulation of cannabis up to the individual states. Those that support this States’ rights argument fear that federal lawmakers will overlook crafting legislation that protects the local small marijuana operators who pioneered the space in the first place. In the law-of-the-jungle where big eats small, these operators who bootstrapped their way into business and struggled through the expensive and arduous process of becoming licensed would now face the inevitable treat of big businesses consuming the market.  Keeping the power to regulate at the state and local levels could protect what these small businesses have contributed to their communities. Back to a cynical tone, the argument is that the federal government has never gotten it right yet on laws regarding cannabis, why would one believe they will get national legalization right?

Legalization Impact on Cannabis CRE

Nevertheless, the positive effect on the commercial real estate market is being felt immediately upon state legalization.  In New York, for example, a study done by MPG Consulting for the New York Cannabis Industry Association, reported that legal cannabis sales in The Empire State are projected to be $1.2 billion by 2023, with the potential of rising to an estimated $4.2 billion by 2027.  The impact on the real estate market in the state was shown by the estimate that 900 cannabis retail outlets will be opened by 2027.  To meet the demand created by this retail exposure it was calculated that 2.5 million square feet of canopy would be required.

Trends forecast by Forbes for commercial real estate, in general, this year will be accommodating for Cannabis CRE transactions:

  • Forbes predicts there will be more distress asset sales from sectors slow to rebound from COVID-19.
  • Work from home will put more commercial space on the market.
  • To continue to aid the economic recovery the Federal Reserve is likely to keep short-term interest rates low throughout the year. This could also be a favorable development for the cannabis industry that has been plagued by being forced to pay higher interest rates on debt in the past.

Another interesting twist coming out of COVID is that real estate investors are seeing capital reallocated to businesses that were classified as “essential.” More capital is now flowing to grocery stores, dollar stores, auto parts and service centers, pharmacies, medical companies and fast food. These are considered ideal tenants.  Cannabis is entering that category as well since cannabis is included as an essential service in 28 of the 37 legal states.

Regarding the rapid pace of the current growth of legalization on the state-by-state basis, WealthManagement reports that it usually takes as much as two years for a cannabis market to start gaining traction in newly legalized states. Due to the enormous need for increased revenue that every state faces coming out of the Pandemic, more states are streamlining the sanctioning process, even down to the municipality level, to expedite the flow of new tax revenue.

Smart Money Flowing into Cannabis CRE

The booming marketplace this year is generating renewed interest in cannabis CRE investments.  Not only are more debt funding options becoming available to cannabis operators, but also how well the cannabis industry performed during the COVID-19 crisis has shown traditional financing sources and formerly reluctant landlords that the cannabis industry exhibits recession-proof qualities. Neglected store fronts in formerly derelict areas and industrial warehouses continue to escalate in value brought on by industry expansion, particularly into areas dedicated as Green Zones within municipalities.

A Green Zone is an area designated where legal cannabis/cannabis-related businesses are allowed/encouraged to set up cultivation, manufacturing and retailing facilities.  One funding resource, Canna-Hemp Debt Fund , estimates that industrial warehouses they are underwriting that are “green zoned” show at least a 20 to 30% in increase value.  For debt loans the company feels comfortable with LTVs of 60-65% in their green zoned properties.  For investor security, and to be able to offer lower than market rates, personal guarantees and cross corporate guarantees, wherever possible, are required from their borrowers.

Green Zones designated within Qualified Opportunity Zones (QOZs) offer investors the additional benefit of the potential of deferred and reduced taxes on capital gains while building equity in property purchased within the zone.  This provides the benefits of economic improvement and job creation to the surrounding low-income, distressed neighborhood.  While cannabis businesses are still subject to tax code 280E, which eliminates operational business expense deductions for income tax purposes, the current IRS ruling gives the owner of a QOZ property a hold on capital gains taxes if the property is held for a minimum of 10 years.

Because of the vagaries of the federal regulations and the laws in each municipality, and those that pertain to each individual property, the first step in any cannabis CRE investment is to always seek advice from professionals experienced in the nuances of the cannabis industry.

What to Look for in Cannabis CRE Properties?

When advising our clients who are considering cannabis CRE investments, here is the guidance we provide:

  • Yes, it is about “Location, Location, Location.” In the case of cannabis CRE, though, location due diligence is crucial. Not only do the laws on the books relative to the property need scrutiny, but also a clear understanding of the support of community leaders for the cannabis enterprise is essential.
  • Legal and CPA advice is vital in order to make sure risk and liability is reduced and all the potential tax savings are to be realized from the property.
  • In certain cases ownership of the property as a separate entity from the cannabis business is a consideration in order to realize the greatest value from the investment.
  • Local ordinances must be thoroughly comprehended in the operations plan for the property.
  • Tax requirements vary from municipality to municipality and other ordinances may apply, even including those that may require a prescribed number of employees to be residents of the area in which the cannabis business is located.
  • This can be a burden or an advantage for an investor. Due to limited amount of suitable properties available in many areas, investors who obtain local licensing and entitlements prior to putting a property up for sale or lease are likely to experience the greatest boost in value.
  • For most states, in fact, the guideline is to have proof that a location for the cannabis operation, in the form of a lease option or sale agreement, has been secured before applying for the license.
  • Rudimentary loan applicant qualifications met.
    • Sellers with credit ratings below 799 should work on ways to reduce debt- to-credit ratio to qualify and improve interest rate. This is a process, though, that takes time to improve.
  • Effective planning and budgeting are crucial to achieving the ROI potential of the property. Some of the main components that a business plan should include are:
  • What the cannabis business will achieve.
  • What are the 5-Ps of Marketing that will lead to achieving business goals – the Product, Price, Place (Distribution), Promotion, and the People that will create and effectively manage a new multimillion-dollar operation.
  • Detailed financial analysis, in which cash flow will be a critical measure of expected performance by lenders. And, all anticipated business expenses should be considered, especially those unique to cannabis since many can’t be considered deductible expenses under the provisions of tax code 280E– the section of the Internal Revenue Code that denies deductions of business expenses by plant touching businesses, in some cases doubling tax rates and minimizing or eliminating cash flow. Cannabis entrepreneurs must pay more attention to this in their financial projections.
  • Is risk mitigated by the loan applicant collateral?

Typically, real estate agents aren’t attuned to stringent cannabis regulations. Advice from experts who are successfully transacting in the cannabis industry is imperative.

Debt Financing Options for Cannabis CRE

The upward trend began in 2018 and advanced well into 2019 when about 30% of all capital raised in the cannabis industry was through debt financing, compared to only 19% in the boom year of 2018.  We are seeing more groups already this year starting both dedicated debt funds and allocating a portion of funds for cannabis debt deals.

While the industry has been capital-constrained, borrowing against assets has been a key source available for many cannabis companies to pursue. Vertically integrated cannabis companies often have significant real estate and other assets that can be leveraged. What has changed now, though, is that more debt providers have come online over the past couple of years addressing a range of needs.  This means that cannabis companies can now refinance at more attractive rates.

Investor Takeaway

Currently 37 states, the District of Columbia, Guam, Puerto Rico, the Northern Mariana Islands, and the U.S. Virgin Islands have legalized medical marijuana programs. 18 of those states and DC have approved cannabis for legal adult consumption. Last week the industry data research and analytics firm, Headset, forecast that the U.S. legal cannabis market will surpass $30 billion in sales next year. This booming marketplace is generating renewed interest in cannabis CRE investments.  Not only are more debt funding options becoming available to cannabis operators, but also how well the cannabis industry performed during the COVID-19 crisis has shown traditional financing sources and formerly reluctant landlords that the cannabis industry exhibits recession-proof qualities. Interest is intensifying in the above-market-value, profitable cannabis CRE investments. Federal legalization would likely streamline the cannabis marketplace, although arguments in favor of States’ rights have also arisen. To make cannabis CRE investments productive in the midst of this volatile industry requires a resource that completely understands the national, state and municipality laws, the local ordinances, and the attitude of the community in which a property is located in order to expedite the process of a CRE investment destined to achieve a well-planned ROI.

How We Can Help

Next Step – Category Expertise Needed

After six long years processing millions of dollars in successful sell-side and buy-side transactions, we know the cannabis industry. We excel at structuring deals to meet client investment strategies in opportunities with our core expertise in Cannabis.  And, we transact in other highly regulated markets in the fields of Pharma, Biotech, Healthcare, Agtech, Clean/ClimateTech, and CBD/hemp companies. We specialize in thoroughly vetted companies looking to drive growth and enterprise valuations through M&A, non-dilutive debt financing and/or capital investments.

Let’s talk about putting the power of this expertise to work for you as a Sell-side or Buy-side client.

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