The real estate industry has been on a high after the legalization of marijuana, but as we examined in “Part 1: The Real Estate Bloom,” getting involved in this budding industry comes with risks, the majority of which stem from marijuana being listed as an illegal Schedule I drug under the federal Controlled Substances Act (CSA). Under the CSA, it is illegal to possess, cultivate, and/or sell marijuana or to “knowingly open, lease, rent, use or maintain any place … for the purpose of manufacturing, distributing, or using any controlled substance.” Additionally, under the Comprehensive Drug Abuse Prevention and Control Act, the federal government is allowed to seize property that is connected to illegal drug activity. This federal illegality opens up the marijuana industry to a number of vulnerabilities. Indeed, federal prosecution of marijuana activities has been relaxed after the issuance of the Cole Memorandum, which instructed federal prosecutors to only focus its efforts on certain issues related to the legalization of marijuana in the states. Such issues include, among others, preventing the distribution of marijuana to minors, preventing marijuana revenue from ending up in the hands of criminal enterprises, and preventing the diversion of marijuana across state lines. However, although the Cole Memorandum resulted in the federal government taking a hands-off approach in its enforcement of cannabis prohibition, we may see a federal push back under the current administration, which has repeatedly expressed its opposition to the legalization of cannabis.
Due to a marijuana business being subject to a potential seizure by the federal government, one of the most considerable obstacles has been the issue of obtaining financing. Most banks will not provide mortgages to buildings used by the cannabis industry due to their collateral being susceptible to seizure by the federal government. As a solution to this problem, businesses have been increasingly turning to hard money lenders or raising equity by selling ownership stakes to private equity and venture capital funds. REITs have seen this as an opportunity to provide an alternative to traditional finance options by raising capital through acquiring and leasing back real estate assets.
With investors being more willing to get involved in the industry, many REITs have been established to focus exclusively on the cannabis industry. Innovative Industrial Properties Inc. (IIPR), the first cannabis-focused REIT, went public on December 1, 2016, with an initial public offering price of $20 per share. In May 2017, Atlantic Alliance Partnership (AAP) merged with Kalyx Development to create the company Kalyx Properties, which will focus on leasing operational facilities to cultivators. Other examples of REITs that have dipped their feet in this industry include Pacific Century Holdings and Doyen Elements. However, limitations exist on where REITs will invest. For example, many REITs will not invest in dispensaries, and will only invest in regulated areas where there is a level of comfort.
Another challenge stemming from marijuana’s federal illegality is the issue of how to pay for the product. As a Schedule I drug under federal law, marijuana cannot be bought with a credit card, and dispensaries cannot be issued corporate credit cards. As a result, cannabis is an industry of cash, and tenants expect landlords to accept rent payments in cash. When a landlord deposits cash of over $10,000, the bank is required to submit a suspicious-activity report to the federal government. Although landlords have tried to protect themselves in their leases by prohibiting tenants from paying in cash, tenants have instead resorted to paying rent via a money order, which carries the same federal reporting requirements as cash. Moreover, because the rent being paid to the landlord is derived from the sale of cannabis, it is technically money laundering. One solution to this dilemma has been blockchains, which are online ledgers that record and process transactions that are made in digital currencies like bitcoin. Companies such as Tokken, have provided blockchain technology as a method of banking to the marijuana industry. Blockchain transactions are irrevocable, thus giving marijuana dispensaries and banks a complete and detailed record of Tokken transactions. Blockchain companies are even exploring how they can provide a means of lending.
While the federal legalization of marijuana would solve many of the foregoing problems, it comes with its own ramifications. The legalization of marijuana at the federal level would likely lead to interstate commerce, potentially putting growers in more expensive cultivating locations out of business. For example, growing in Massachusetts must be done indoors and is thus is far more expensive than growing in California. Interstate commerce would allow for California’s crop to be shipped to Massachusetts, thus decreasing, and eventually eliminating a demand for Massachusetts’ grown marijuana.
Beyond the federal legal risks are those at the state and local level. Each state that has legalized the use of marijuana has enacted a different set of laws, and the same holds true for local ordinances. This means that state and local regulations must be strictly followed in order for a marijuana business to legally operate. As such, landlords of marijuana businesses must spend the time and resources to ensure that their tenants are in compliance with their city and state laws and that their operations have been adapted accordingly.
Beyond the legal risks are the operational risks. Industrial facilities must be retrofitted for marijuana cultivation, which can often cost millions. Moreover, as discussed previously, running an indoor marijuana grow facility comes with extremely high electricity costs due to the powerful lights that are required to grow the plants. In addition to these costs, water costs will also likely increase as experts believe that competition for water will be intensified, especially in areas along the northern coast of California. In areas where cannabis has been legal for quite some time, the price of cannabis has been dropping, which means that marijuana cultivators must find a more efficient means of growing their crop in order to pay their high rental costs, while, at the same time, turn a profit. In Rents, Refi’s, and Reefer Madness: How Legal is Legalized Marijuana for Landlords and Their Lenders, J. Marcus Painter points out that warehouse grow facilities have also faced wear and tear issues due to the impacts that the presence of marijuana plants, products and processes have had on the facilities, and that such impacts create high re-tenanting expenses and result in lower appraisals and loan curtailment payments.
Those who have been willing to enter the marijuana industry despite these risks have seen reward. But, with California’s law becoming effective on January 1, 2018, and officially legalizing the recreational use of marijuana, new challenges may arise. Such challenges and a closer look at California’s law will be discussed in the next part of this series.