SPACE TO GROW Part 3:  Rent, Security Deposit, and Collateral Issues

The legalization of marijuana presents significant opportunities for property owners looking to cash in on California’s budding cannabis industry. But what do people really know? 

Connect Media turned to a pair of panelists at our recent Connect Los Angeles conference, Cox, Castle & Nicholson’s Amir Sadr and David Wensley, for a deep dive into a burgeoning CRE sector. The lawyers shared insights into what’s taking place, how it impacts landlords, lease considerations, rent, security deposit, and collateral issues and what commercial real estate industry players need to know now.

This is our final installment in our special three-part report on cannabis and CRE. The first part explored regulatory framework and local jurisdiction licensing. Sadr and Wensley covered lease provisions and considerations in the second part. In this week’s installment, they take a deep-dive into rent, security deposits and collateral issues.

Sadar and Wensley

By Amir Sadr and David Wensley

Due to the extensive regulations and jurisdictional control over cannabis businesses, properties suitable and available for cannabis operations may, due to limited supply vis à vis increasing demand, command greater rents. Property owners have generally demanded higher rents and greater security to offset the perceived risks in leasing to a cannabis operator, as opposed to a more traditional tenant. These risks include the possibility that the cannabis business will not be able to maintain its required licenses, and will be shut down by governmental authorities; the federal government will no longer refrain from prosecuting federal laws against California cannabis operators, despite compliance with state and local laws; and the fear of potential negative stigma for surrounding tenants and businesses, mandating additional consideration from property owners that lease to a cannabis operator.

To address these risks, in addition to higher rents, property owners should also consider whether extraordinary security or collateral to secure performance by the cannabis operator is warranted. A larger security deposit, letter of credit, or personal guaranty of a financially creditworthy party should be considered to secure the cannabis tenant’s obligations to pay rent, comply with applicable laws, and surrender and restore the premises timely upon lease expiration or earlier termination.

Unique Use Controls.

Whether through traditional agricultural means or industrial indoor grow operations, cannabis growers present unique issues that property owners need to consider. For example, indoor cannabis farming operations typically require extraordinary electricity and water use beyond that of other indoor industrial uses. These extra costs are typically passed through to the operator in a single-tenant scenario, however in a multitenant project the lease should address methods for measuring and charging the cannabis operator appropriately for its potentially extraordinary use.

In addition, cannabis businesses remain largely cash-based due to the illegality of cannabis operations under federal law. It may be appropriate to consider drafting lease provisions that recognize the significant amounts of cash that may be held on the premises, and necessitate unique protections or increased security at the property to mitigate potential vandalism and theft. Under MAUCRSA, alarm systems, commercial grade locks, secure storage, and 24-hour video surveillance are required for any area containing cannabis and cannabis products. Leases should be drafted to appropriately allocate the burden of such additional risks and costs, as between the landlord and the cannabis operator.

For multitenant projects and buildings, property owners and their legal counsel must examine whether the intended cannabis operation is permitted under existing private covenants, including CC&Rs (covenants, conditions, and restrictions) and leases with other tenants at the property. Many institutional quality projects are encumbered by private restrictions or leases that may prohibit cannabis operations. In the retail arena, many national and regional retail operators insist on imposing restrictions on the landlord against various “undesirable” uses, which may expressly or by implication include cannabis operations.

Required Licenses and Notice.

Lease agreements with cannabis operators, as noted, should include an express covenant requiring the operator to obtain and continuously maintain any and all necessary permits, licenses, or governmental approvals required for use of the premises. These leases should also include a provision requiring the cannabis operator to provide the landlord with a copy of all permits, and impose an obligation to notify the landlord of receipt of any notice from federal, state, or local authorities relating to the tenant’s cannabis operations.

Operations/Odor/Nuisance/Loitering.

As the smell and nature of the cannabis plant is distinct, a lease should include strict language protecting against issues relating to nuisance, odor, and pests in and around the premises. Landlords may wish to consider requiring above-standard ventilation and filtration systems to prevent the odor and other forms of nuisance from impacting adjacent tenants and businesses. In addition, the lease should include language to prevent loitering by customers, and the presence of persons under the influence or appearing to be under the influence in and around the premises.

Lending.

Since cannabis remains illegal at the federal level, a pressing challenge for real property owners and investors considering leasing to a cannabis operator is the impact of a potential “illegal use” on the property owner’s existing or contemplated real property financing. Most, if not all, real property loan agreements, deeds of trust, mortgages, and related security agreements contain provisions requiring the borrower to keep the subject property in compliance with all applicable laws, and advising that the subject property may not be used for illegal activities. Consequently, most traditional lenders are presently un-willing to lend on property leased for cannabis operations, and such an operation could be a violation of the express terms of the governing loan documents. Attorneys should discuss with their clients whether there is existing or contemplated financing for the property, and, if so, the client should be advised that leasing to a cannabis operator may run afoul of their obligations to their lenders and compromise their financing arrangements.

Progressing Landscape.

Whether one favors or opposes legal cannabis, most Californians can agree that legal cannabis operations will have a significant impact on the state’s economy and its commercial real estate industry. Commercial cannabis activity in California is expected to add significant tax revenue to state and local government through licensing fees and taxes. Property values in cities and counties permitting cannabis businesses have already skyrocketed in California, and will likely continue to do so until supply matches demand. Factories, warehouses, and self-storage facilities, among other property types, have been transformed into cultivation sites for cannabis grow operations. Retail storefronts have been repurposed to top-quality cannabis dispensaries, with finishes comparable to those of other more traditional major retail tenants. Real property owners and state agencies alike must continue to evaluate this progressing landscape in search of ways to legally profit from the cannabis industry.

It is important to understand that all commercial real estate contracts and transactions are unique, as is the real property involved. Cannabis laws in California at the state and local levels are rapidly changing. Effective representation of commercial real property owners contemplating leasing property to a cannabis-related business or a cannabis operator will require an expertise in this area of law,and the ability to stay apprised of new developments for a quickly-evolving and highly-regulated industry.

For comments, questions or concerns, please contact Dennis Kaiser