Cannabis and Real Estate Lending; Securing Opportunity in the Face of Widespread Fear
Despite an exceptionally poor year of revenue and returns, the cannabis industry is still very much in its infancy stage with massive expectations for the next five years. While the greater economy continues to struggle, and the media pushes a fearmongering narrative of a hopeless industry, it’s more important now than ever to take a 30,000-foot view of what’s really happening. In the last several years there has been a domino effect of states legalizing recreational cannabis with New York and New Jersey creating a flurry of excitement in early 2021. Driven by the fear of missing out on the opportunity, retail investors and institutional capital alike responded by flooding the market. With the benefit of hindsight, it appears that this early hype was premature, and the torrent of capital was mistimed. As a result, losses since that time have been exorbitant and highly public, expectations have deflated, and what was once a flood of capital has slowed to a mere trickle. An industry previously drunk on optimism is slowly becoming poisoned by pessimism and cynicism. For evidence of this change, look no further than the Innovative Industrial Properties, Inc. v. Kings Garden lawsuit. The media’s hyperfocus on a massive cannabis operator’s default on rent payments completely ignores the reality that the dispute, and financial woes, largely centers around accusations of fraud. To make matters worse, the Safe Banking Act failed once again, this time in a government where Democrats controlled the Presidency and both houses of Congress. With a divided Congress entering the back half of Biden’s administration, it seems that only more bad news is in store for those hopeful of banking changes in the next four years.
Although confidence is down, the truth is that cannabis sales are continuing to grow nationally, albeit in an increasingly competitive market. BDSA (the leading market research firm covering the legal cannabis market) recently released its market forecast stating that cannabis sales are expected to increase in the United States from $25 billion in 2021 to $40 billion in 2026, and from $30 billion in 2021 to $55 billion in 2026 globally, a compound annual growth rate of almost 13%. MJBiz Daily has gone so far as to predict that cannabis sales will outpace over-the-counter medication sales by the end of 2023. With such lofty expectations, the industry will be in dire need of significant funding to fuel this furious growth – the key as a debt financier is to find the winners and know how to protect yourself against the losers. Every successful debt lender has different investment metrics, modes of assessment, and year-over-year goals, however, when evaluating a deal with marijuana-related-businesses (“MRBs”) one must intimately understand not only the roadblocks to recourse that don’t exist in traditional industries, but strategies to protect against an unclear market. This discussion only scrapes the surface of factors to consider.
Collateral Assessment Separate from Cannabis
If you’ve participated in a cannabis-touching financing transaction, then you know that license holders vastly overvalue their licenses. The hype discussed above and the idea that a cannabis license is a golden ticket to wealth and prosperity have warped the minds of otherwise rational people. In actuality, the industry is volatile and heavily regulated, competition is fierce, there is a myriad of operational roadblocks that lie between the receipt of a license and actual year-over-year profit, and state/county regulators have proven unreliable. Furthermore, lenders of course cannot possess or sell cannabis without a license, and therefore, following a borrower default, the value of cannabis is potentially nominal. Without intentionally structured and forward-looking documentation, a mortgage lender’s main recourse rights are largely limited to the liquidation of real estate and equipment, not the associated inventory. Therefore, when underwriting a deal, it is extremely important to assign a collateral valuation from a more traditional viewpoint. Specifically, underwrite the real property operations separate and apart from an MRB; consider a more robust guaranty structure than would typically be required (i.e. carveout guaranties may not be sufficient); cross-collateralize your MRB property with others unrelated to the cannabis operations – the strategies are endless and often require creative thinking. While a more conservative approach may bar certain fringe deals, the pool of available lenders is smaller than ever giving
significant leverage to those who are willing. An intentional and patient approach allows for top-of-the market returns while remaining safe and protected through the compilation of a more “traditional” portfolio of assets (for a real-time example of strategies to avoid and why, I encourage anyone reading this article to brush up on the shareholder lawsuit being leveled against Innovative Industrial Properties, Inc. – the same lender in the Kings Garden lawsuit referenced above – which, per Blue Orca Capital’s April 2022 report, is “a marijuana bank masquerading as a REIT”).
Security Agreements in Uncertain Times
In any secured transaction, the value of collateral is what matters most. In the cannabis industry, apart from real property, items such as the business ownership interests, licenses, inventory, equipment and accounts receivable remain the top focus of my clients. However, unlike in more traditional secured transactions, foreclosing on a cannabis business and its secured assets depends largely on state law, which is often a very complicated process. First, it’s important to understand your enforcement rights – in general, states with laws that recognize commercial cannabis conduct as legal will enforce cannabis contracts despite the federal bar and therefore smart lenders will craft their security agreements to be enforceable in the state in which the dispute is handled (i.e. your boilerplate Delaware law security agreement may not cut it). Second, related and similarly important, the issue of state-required disclosures remains a massive hurdle to lenders nationwide. In almost all states where cannabis is legal, state licenses are not transferable, and they therefore cannot be listed as individual collateral in a security agreement. When securing its interest in collateral, a lender should therefore require the MRB to pledge its equity interests in a separate security agreement as opposed to a pledge of the license itself.
In addition, if a lender wants access to its customer’s cash flow, accounts receivable or inventory via a security agreement, it must, of course, first become an “owner” of the entity, which creates its own complex and lengthy regulatory process beyond the confines of the applicable state UCC. Specifically, if the collateral list includes ownership interests in a cannabis business or its inventory, then to foreclose, you will have to first go through mandatory personal and financial disclosures with the applicable control board – a process that currently remains murky in most states and typically would cause the appropriate review board to cancel the license. However, regardless of whether you do in fact foreclose on a pledge agreement, holding an enforceable security agreement gives you the keys to the company and provides a huge amount of leverage following a default – just another tool in your box that should not be overlooked. In short, standard security agreements and strategies for securing collateral are lacking in the cannabis industry. However, a calculated strategy at the outset with intentional language can provide a significant hedge against liability and losses if your deal goes sideways. While the standard foreclosure procedure for security agreements may not currently be on par with traditional industries, cannabis regulations are ever evolving. Tying together all elements of your collateral remains more crucial in this industry than ever.
Organizational Review – Control Rights and Equity
In addition to the complexities specifically related to dealing with cannabis, standard KYC due diligence requirements surrounding financial institutions are of course applicable here, as well. However, with certain states requiring unique eligibility requirements (see New York and New Jersey’s social equity approach), in addition to black market proximity and the previously discussed flurry of early investments, organizational structures of many of these MRB’s are convoluted, poorly documented and oftentimes structured to hide outside interests. Regardless of the presence of cannabis, a lender in this space is obligated to follow all KYC regulations applicable to financial institutions. When doing so, I always insist that my clients identify any entity/individual who maintains any control rights over a borrower or guarantor (i.e., not just “major” control rights), in addition to running to ground any entity/individual who owns a 10% or greater interest in one’s borrower. While 10% is beyond the minimum statutory requirements, this process forces a sponsor to disclose otherwise hidden areas of their organizational structure and exposes the true makeup of one’s entity. It’s a simple approach that requires a careful and thorough review of all organizational documents, starting with your borrower and guarantors, and running up the chain until control lies with a warm-bodied individual and all equity interests are identified and certified as true and accurate. KYC regulations are never to be ignored as audits can come at any time, and this is truer in the cannabis industry than anywhere else.
Audit Rights and Strategic Foresight
As alluded to above, a mortgage lender’s ability to access its collateral following financial distress will largely hinge not only on the value of the secured property, but on the interplay of cannabis laws at the county and state levels. Like any regulated industry, compliance with applicable regulatory bodies is obviously important – in the cannabis industry, it’s paramount. Given the significant hurdles to a lender accessing cannabis-related inventory or cash flow following a loan default, taking calculated steps to ensure that your borrower remains compliant should be front and center when discussing a term sheet or when negotiating loan documents. Step 1 is ensuring current compliance at closing. While Step 1 may be relatively simple and straightforward, Step 2 is both crucial and complex. Step 2 requires that the lender build in procedures that grant you real-time access to the operations of the borrower during the term of your loan. When compared to traditional financing arrangements, this enhanced process necessitates adding robust inspection and audit rights to your loan package to monitor and guard against potential noncompliance. Minor actions such as baked-in requirements for quarterly delivery of financial statements and P&L reports, requiring simultaneous delivery of all annual fee payments, untethered audit rights for inspecting your client’s books, and a strict restriction on transfers, are strategies that could save you millions of dollars. These should not be treated as rights to trade when negotiating your loan package; these should be your baseline.
While the most visible opinions towards the legal cannabis industry in the US are low, those who are knowledgeable and well-versed in the market remain bullish and are poised to capitalize. Real monetary success does not come without risk and approaching this industry with an appreciation and understanding of the unique pain points that are at play is paramount. Working with knowledgeable people who are experienced in these evolving issues will mean the difference between success and failure.