Cannabis Real Estate Lease and Risk Management Considerations

Negotiating a well-crafted cannabis real estate lease can be challenging but also presents many profitable opportunities for discerning land owners, tenants, and investors.

Recreational and medicinal cannabis is now legal in California. Landowners and lessees are entering into real estate lease transactions to grow, produce, distribute, and sell cannabis-related products. The National Association of Realtors (NAR) Research Group’s “Marijuana and Real Estate: A Budding Issue” November 2018 Report states approximately 34% of their respondents had experienced an increase in demand for warehouses and storefronts and approximately 18% had seen an increase in demand for raw land on which to build cannabis-related facilities. The legalization of cannabis presents many exciting and profitable opportunities for land owners, tenants, and investors. With these opportunities comes the important challenge of negotiating and documenting the unique economic and legal aspects of a cannabis real estate lease.

A well-crafted lease improves one’s ability to obtain investment funding and should allow one to adapt to the rapidly changing laws, rules, and regulations.

In addition to landlords and lessees, investors and financing sources care about the terms of a lease, as they are concerned about protecting their interests. Title insurance companies care about the terms of a lease as they evaluate whether to issue title insurance in a transaction. California cities and the State are developing regulations that impact lease arrangements as they seek to capitalize on the promise of greater tax revenue. In Los Angeles, the Department of Cannabis Regulation (DCR) is the agency primarily responsible for promulgating and enforcing regulations affecting participants in the cannabis growing, sale, and distribution of the plant and extracts.

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When negotiating and documenting a lease, parties to that lease must consider the unique aspects and requirements of the cannabis industry, as well as regulatory considerations and investor concerns. For example, many potential tenants must have a valid license to legally grow, harvest, extract oils, fabricate, and distribute a retail product. Without a valid government sanctioned license, all parties will be exposed to significant economic losses and other consequences frequently associated with governmental enforcement.

A leasing relationship should not be oral or written on napkins or the back of an envelope. It is critical to consider the nature of the property to be leased. Is the lease for a growing facility, warehouse or storefront? Each use requires a different approach and different language in a lease.

What minimum provisions should the parties consider incorporating into or resisting in a “cannabis” lease? Should a standard form of commercial lease be used? There appears to be a difference of opinion on this issue. Approximately 50% of NAR members reported that they did not add additional language focusing on cannabis to their clients’ leases while approximately 20% of NAR members reported adding some sort of addendum. At a minimum, incorporating an addendum into a lease will likely capture the unique aspects of the cannabis transaction. In the long run, the cost of a fully custom lease may be less, as standard form leases often contain language ambiguities and arguably inconsistent provisions that are problematic if the parties find themselves in a dispute.

The following is a list of business and legal considerations to be considered when negotiating and documenting a lease involving a cannabis or hemp facility.

  • Utility expense allocation. When a tenant grows on or in the property, electricity and water demand may be significant. The NAR reports that approximately 1% of landlords pay tenant utilities. Therefore, the tenant should assume the responsibility to provide such utilities.
  • Revenue management. The cannabis industry is currently a cash business. Cannabis is a Schedule 1 narcotic and the banking industry is largely unavailable. Landlords must consider how they will receive rental payments. In cash? The NAR reports that approximately 25% of landlords were unwilling to take cash for rent but approximately 22% would take cash without questioning the source. What about banks? Banks are leery of taking significant deposits from any activity “touching the plant.”
  • Criminal activity. Does establishment of storefronts or grow warehouses attract crime? The data is inconclusive, as 28% of NAR members cited no change in crime while 8% reported an increase. What security arrangements should be considered and implemented?
  • Odors and scents. Cannabis does not emit a perfumed fragrance. The smell of a cannabis processing or marketing business can permeate adjacent businesses. Confirm the proposed premises are located in a place that permits the anticipated use and is not likely to offend neighbors who could complain to governmental bodies and potentially institute legal action to close a facility.
  • Compliance with state and local cannabis law. Cannabis is a Schedule 1 drug. It is illegal on the federal level. Most leases prohibit a tenant from engaging in unlawful activities on the premises. Leases should contain representations that the tenant’s use of the premises is lawful and that the tenant has not received written notice from a governmental or other party contesting compliance with such law. A lease should contain express language that spells out cannabis cultivation, sale, and distribution (as the case may be), and confirm that the activity is not deemed to fall into the category of illegal substance, but is a permitted use, notwithstanding its noncompliance with federal law.
  • Licenses, permits, investigations, and landlord’s cooperation. Many leases require the parties to cooperate with each other. Language should be incorporated into a lease that requires a lessor to cooperate with the tenant in connection with the tenant’s processing its license to do business.
  • Indemnification and forfeiture. What if the lease arrangement violates a law that enables the State to assert a claim of forfeiture against a lessor? Consider whether the tenant should be responsible for defending a lessor in such circumstance and indemnifying the lessor for any and all losses associated with such an event.
  • Default management. This is an area where precision in drafting is critical. It serves little purpose if default triggers with respect to the tenant are too low, or if there is not a reasonable opportunity to fix a problem (unless it’s for the payment of rent). The duration of cure provisions frequently ranges from a few days to a couple of months if the tenant is diligently working on a cure. However, what if the cure is outside of the tenant’s control (e.g., the need for a regulatory approval)? The parties will need to negotiate the appropriate mechanisms that will avoid default and manage the cure process before proceeding with the eviction process.

On the other hand, what if the lessor’s lender deems the lessor’s cannabis lease to be a default under the lessor’s financing and calls the loan? Should the tenant have an obligation to participate in a refinancing of the underlying property? Should the tenant have an obligation to provide refinancing?

CONCLUSION

The business opportunities presented to landlords, tenants, investors, and governmental bodies by the legalization of cannabis in California is exciting! With proper attention to the unique aspects of a real estate cannabis transaction, all participants can achieve desired results and be in the best position possible to adapt to changing laws, rules, and regulations.

[For more on Thompson Coburn’s approach to Mergers & Acquisitions click here]

Disclaimer: Cannabis laws and policies in California and elsewhere are constantly evolving and subject to change. The labels, information and explanations in this article are quite limited in their scope and for informational and discussion purposes only and not meant to provide comprehensive descriptions or discussions of the topics mentioned herein. No warranty is given as to the completeness or accuracy of the information contained herein and the views and opinions herein are subject to change without notice. This article is not nor may be deemed, under any circumstances, to be legal advice from Fox Rothschild, LLP (“Fox”) or the lawyers named herein. No attorney-client relationship currently exists with the recipient nor may exist with Fox without a signed written engagement agreement among the parties. In furnishing the information above, the author reserves the right to supplement, amend or replace such information at any time with no obligation to provide the recipient with any supplemental, amended, replacement or additional information.

 

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