Prepared for Global Cannabis Investor Magazine
Written by Rick Payne | Co-Founder of Cannabis Real Estate Consultants
Traditional Commercial Real Estate Market Trends in the United States
Trade war talks with China, the popularity of online shopping for American consumers, and the death of “big box” retailers has begun to transform the demand for various asset classes in the traditional investment markets.
Over the past decade the United States commercial real estate market has undergone a historical cycle that could be compared to a roller coaster ride. After the housing crisis and the economic meltdown that ensued shorty after in 2008 and the years to follow, the stabilization of the capital markets has been a slow, yet steady and consistent process that has resulted in what most investors and analysts would describe as a “healthy” market with strong growth. Although the current trends are vastly different than they were a decade ago and the market demands have undergone a complete transformation, there is a substantial amount of stability in certain commercial real estate asset classes
such as industrial, multifamily, central business district (“CBD”) office space, and even retail in certain instances.
The most stable asset class with the highest demand, lowest vacancy rates, most new construction, and stable growth is undoubtedly industrial. In 2019 it was estimated that roughly 88% of cap rates for industrial investments ranged on average anywhere from 4.6% to 8.0%. This can be attributed to the rising popularity of third-party logistics providers and other B2C businesses that are focused on home delivery to their customers such as Amazon. Even retailers that traditionally relied on large spaces for their operations such as Home Depot, Walmart, and Best Buy are all beginning to deploy some type of home delivery service to remain competitive.
“The most stable asset class … is undoubtedly industrial.”
Cannabis Real Estate as a New Asset Class
The unique operational requirements of cannabis businesses and complex government regulations related to zoning and land use for the cannabis industry have created an extraordinary opportunity for commercial real estate investors looking to capitalize on a thriving new industry.
Commercial cannabis operations have become as commonplace as Starbucks in certain parts of the United States. Considering the fact that there are now 33 medical marijuana states and 11 adult use marijuana states it is safe to say that the chances are that the majority of Americans have been exposed to the cannabis industry in their hometown or state one way or another. This is even more pronounced in states like California that have had an established and burgeoning medical cannabis system in place for over two decades since 1996.
As legalization has spread throughout the U.S., there have been a number of states, like California, that have opted to give local municipalities the authority to ban or regulate commercial cannabis activity within their city or county limits. For instance, the State of California has 482 cities and 58 counties for a total of 540 different municipalities. Each municipality has their own set of laws and there are still over more than half of the 482 cities in California that have outlawed dispensaries, deliveries, or any type of cannabis sales despite the recent state law, Proposition 64, which legalized recreational cannabis businesses.
To add insult to injury, cannabis is technically still federally illegal since it is considered a Schedule I Controlled Substance under the Controlled Substances Act. Because of its federal status many landlords in the past have been apprehensive about renting their property to cannabis businesses. It can often cause complications if there is a loan on the property. Typically, lenders will get what is referred to as a “rent roll” on a frequent basis from their borrowers. If a lender such as a bank discovers that one of the tenants in a building that they have a loan on is a cannabis business, they can typically call the loan “due” in which case the borrower has to pay off the entire balance immediately. As you can imagine, this is less than ideal and can often be reason enough for a property owner to decide against leasing their property out to any cannabis businesses.
Supply & Demand of Limited Real Estate
The complex framework and extreme lack of available cities to do business in have created a disproportionate supply and demand. There are substantially more businesses that are trying to get locations and become licensed than there are viable locations that are eligible for commercial cannabis businesses. This overwhelming demand and undersupply of inventory have created a brand new and highly valuable asset class within the commercial real estate market more commonly referred to as “cannabis real estate” nowadays.
“Cannabis Real Estate is any property that is eligible to obtain licenses to operate a cannabis business.”
There are several different verticals within the cannabis industry supply chain and corresponding types of real estate such as cultivation, manufacturing, distribution, testing, retail, delivery, and adult use on site consumption.
Cannabis Industry Supply Chain in California
Cultivation is either grown “outdoor”, “greenhouse”, or “indoor”. Vacant land is most common for outdoor and greenhouse cultivation operations while warehouses and industrial space with a substantial power supply is required for indoor cultivation. Manufacturing is also done in commercial kitchen facilities or industrial warehouse space and also often requires more power for all the equipment used in the operation. Distribution also requires warehouse space, but typically doesn’t require as much power and can often be ran from other types of less industrial space such as flex or even office space if that is all that is available.
Most of the production side of the supply chain such as nurseries, indoor cultivation, manufacturing, and distribution require industrial type real estate typically ranging from as small as 1,000 square feet to as large as 100,000 square feet plus.
The Retail Vertical and It’s Unique Value
Retail operations are by and large the most difficult to accommodate due to the lack of viable locations, but they are also the most in demand and the least in supply. Most retail businesses are required to be a certain distance from schools, daycares, and other types of “sensitive uses” that have been identified by the city or county that is regulating the cannabis activities.
“Most retail locations in California see hundreds or thousands of people per day and sell anywhere from $100,000 per month to upwards of $1,000,000 per month in sales.” Additionally, to prevent oversaturation and “clustering”, typically most jurisdictions require cannabis retail businesses to be at least 600ft to 1000ft away from each other. As a result, most cities or counties only have a couple or a few retail locations if they have any. The lack of abundant retail locations has caused the locations that are able to become licensed retailers to be very successful in terms of generating revenue. Most retail locations in California see hundreds or thousands of people per day and sell anywhere from $100,000 per month to upwards of $1,000,000 per month in sales
As a result of the success that many of these cannabis retailers have experienced (which from the landlord’s standpoint provides higher rent levels), there are now many landlords that are willing to take the risks associated with renting their property out to cannabis businesses.
Cannabis Real Estate Entitlement, Development, and Valuations
Since retail has appeared to emerge as the most stable vertical with consistent growth, real estate developers and other investment groups are realizing the amount of money that stands to be made from entitling properties and securing the necessary licenses to operate. They have also realized that they would prefer to get involved in the cannabis industry or at least investing in it through real estate instead of through actually “touching the plant”. Those involved have quickly learned that there are millions of dollars at stake for going through the development process and obtaining the necessary licenses to become operational. The cost of entitling a property for a proposed cannabis business can range anywhere from tens of thousands of dollars to over a million per location, and that is prior to doing any construction or tenant improvements. Frequently, even upon expenditure of these amounts, there is no guarantee that the applying party will secure the required license. Having said that, the value of a retail license in select markets can be upwards of ten million dollars or event substantially higher. Valuations of 1 to 2x gross revenues are certainly not unheard of presently.
Cannabis Real Estate “Comps” or Lack Thereof
The value of most cannabis businesses is very difficult to quantify since there are relatively very little “comps” or data on previous similar transactions. As an industry standard, most operational businesses are worth somewhere between a multiple of .5x to 2x of their annual gross revenuea . It’s difficult to base company valuations on the net profit or retained earnings since under IRS Tax Code 280E no cannabis business can deduct normal business expenses. As a result, most cannabis operators have to write off the majority of their expenses through the “Cost of Goods Sold” (“COGS”) since that is the only currently accepted type of deduction for cannabis businesses. This is not as much of an issue for cultivators or manufacturers since they can write off virtually everything that goes into their final product, but for retailers that are only able to write off the cost of the inventory that they are selling and this results in more difficulty and expense in operating.
Commercial Real Estate Service Providers
The most valuable type of asset in the cannabis real estate niche is an operational business that is generating revenue and has a “credit worthy tenant”. Given how new the cannabis industry is and how little time most businesses have been established it is very difficult to differentiate the good tenants from the bad ones. However, there are multiple publicly traded companies that have been born from the wave of legalization that has spread throughout the United States and even more private companies that are all competing against each other for the finite number of licenses available. In order to be able to help landlords vet interested parties looking to lease their property, several companies have been formed with the intention of providing asset management and advisory services to property owners and other investors in the cannabis industry. Our company, Cannabis Real Estate Consultants (www.cannabisrealestateconsultants.com) was formed with the intention of being able to assist our clients through various services such as technology, brokerage, compliance, government affairs, and other ancillary services as well.
“…Cannabis Real Estate Consultants was formed with the intention of being able to assist our clients through various services such as technology, brokerage, compliance, government affairs, and other ancillary services as well.”
Real Estate Investment Trusts (REIT) in Cannabis
In the past couple of years there are cannabis REIT’s that have been formed and are targeting various types of investments. We have seen some REIT’s in the cannabis industry aimed at only acquiring assets that are generating 12% to 15% cap rates and have a minimum value of $30mm. The management teams that have been assembled for these various companies are experienced real estate and investment professionals from other industries that have excelled in their space and see an opportunity in transitioning to the cannabis industry. Many analysts attribute the overwhelming success that many of these REIT’s have had to the transfer of professional talent from other industries that are extremely competitive and require talented and educated professionals. Consequently, there are more and more options that are becoming available for investors looking to get in on the green rush without actually touching the plant or really being “in the business”. As the industry continues to evolve and the inevitable legalization on the federal level takes place, there will be another surge in investment capital and equity searching the market for places to invest. The future is bright, and the winners stand to get in on the ground floor of a new era and one of the fastest growing industries in the world, all through real estate if they want, without ever touching one plant.