1 Hazy regulatory environment
Over the past 10 years, 19 states and the District of Columbia have put into place laws that legalize the retail purchase of cannabis for individuals who are at least 21 years old. These laws vary wildly from state to state, causing confusion – and opportunity – for potential market entrants. A key area of uncertainty is whether a state is a so-called ‘limited license’ state, where there is a cap on the number of dispensaries, or if its guidelines are looser.
“We have lobbyists, we have feet on the ground in all the states in which we lend,” says Len Tannenbaum, CEO of Advanced Flower Capital, a mortgage real estate investment trust (REIT) specializing in real estate loans secured by cannabis real estate. The firm is active in the 15 limited license states, where it believes it can be safer to be a lender because there is a cap on competition.
States with looser regulations, such as California, tend to have a glut of competition, which can lead to supply and demand imbalances. “You’ll see some bankruptcies and liquidations in those markets because there is a big oversupply,” Tannenbaum adds.
2 Structuring loans
There are several ways lenders can originate cannabis-related real estate loans, including origination loans collateralized by land or making loans directly to companies. So far, much of the capital being directed toward cannabis-related real estate has come from private investors, according to John Mazarakis, co-founder and chairman of Chicago Atlantic Real Estate Finance, a commercial mortgage REIT focused on lending primarily to state-licensed cannabis operators.
The Chicago-based lender was recently able to upsize its credit facility from $45 million to $65 million, with a cost of capital of about 5 percent. “We’re lending to the cannabis space, with real estate as collateral, and our debt to real estate is under 60 percent loan-to-value. We are trying to stay within conservative, advanced rates, with respect to real estate values,” Mazarakis says.
3 On the sidelines
As the legal cannabis industry expands, big banks and other large lenders have started to look more closely at the potential. Yet, there are still too many questions around state laws and licensing, and the lack of a federal framework, for banks to get comfortable.
“Banks want to lend in this market because it’s real estate-secured,” Tannenbaum says. He notes that these loans also offer richer yields than more mainstream assets. But there are risks associated with a failing business that are different to those in a traditional commercial real estate property.
Banks and other lenders may have asset managers that can operate a multifamily property, for example, but likely do not have the expertise in
overseeing a dispensary or farming operation.
“If a property goes into foreclosure, the bank will own an asset that produces marijuana, with the equipment to do so, and yet the bank cannot [utilize that facility for production],” Tannenbaum says.
Anthony Zeoli, partner at law firm Freeborn & Peters, brings up a further concern: “All the laws we have that exist for contracts or loans are not easily tailored to situations involving cannabis.”
Mortgage REITs, which have emerged as a primary source of capital for this market, are not constrained by the same regulations. “REITs are
sitting in a very good position relative to banks and traditional lenders because they are not subject to the tough monitoring environments the banks are subjected to,” explains Joseph Cioffi, partner at law firm Davis+Gilbert.
Additionally, dispensaries that are engaged in the cannabis industry are not allowed to deduct typical business expenses associated with their activities when filing taxes, according to the Internal Revenue Service 280E Tax Code. “Cannabis companies are prohibited from deducting operating expenses,” Cioffi adds.
4 Inflation angle
Managing a cannabis company is very different than managing a traditional commercial real estate asset, in part because cultivation and storage is highly specialized, expensive and fraught with risks. Additionally, the sector is feeling the impact of record inflation on everything from raw agricultural materials to high-end air filtration systems – these factors are making new properties more difficult to underwrite than existing assets. Finally, there is a disconnect between headline inflation risk and the inflation these operators are seeing.
“The headline inflation is eight percent. But, if you’re in the construction world, it’s up 25 to 30 percent, if not more,” Tannenbaum says. “This means the value of your existing real estate is worth a lot more today than new construction, which is just going to be 30 percent to 50 percent more.”
This economic turbulence could narrow the cannabis real estate playing field sooner rather than later. “Now that we have higher interest rates and inflation driving up costs more, I think you are going to see some liquidations and consolidation at a much faster clip,” Tannenbaum says.
5 No uniformity
While the trend toward cannabis legalization is growing quickly, industry experts do not expect federal legalization and regulation anytime soon. The Safe Banking Act, a law meant to protect cannabis lenders from federal prosecution, has languished in the US Senate for years, despite being passed in the House of Representatives multiple times – most recently in May.
“Other than the Safe Banking Act, I don’t see anything on the horizon federally,” Zeoli says.
For many of the market participants active in this sector, the innovation and uncertainty – and return potential – is part of the appeal. “There is a unique problem-solving aspect to it and that’s why I enjoy it,” Zeoli says. According to Chicago Atlantic Real Estate Finance, a large portion of the US population has accepted cannabis and, says the firm, 67 percent want some form of reform. But finding the silver bullet that will make everyone happy does not come easily, Mazarakis explains.
“That is why we’ve been in this limbo state for a couple of years. Cannabis is still a schedule one substance, which technically ranks federally higher on the illegal scale than cocaine,” Mazarakis notes. “There’s a general acceptance for what we do as being somewhat uncorrelated or counter-cyclical, but the data is somewhat limited. We always expected to have a negative beta. So, we’re very excited about that.”