Via JD Supra
To many in the cannabis industry, REIT is not a common acronym. Yet, as cannabis businesses seek ways to access additional capital, REITs are coming up in more and more conversations.
What is a REIT?
“REIT” stands for Real Estate Investment Trust. Typically, a REIT is a corporation that has elected to be taxed as a REIT (which provides several tax advantages, including the ability to deduct dividends from taxable income). REITs generally raise money from outside sources, often on public markets, and use those funds to buy, develop, operate, and sell income-producing properties. To qualify as a REIT, a company must meet certain qualifications. For example, most of the income of a REIT must be generated by income-producing real properties (e.g. rents, sale proceeds, and interest on mortgages) and it must annually distribute most of its income to shareholders.
There are several types of REITs:
- Equity REITs — own direct or indirect equity interests in real estate – the majority of REITS are publicly traded Equity REITs);
- Mortgage REITs — lend money directly to landlords and operators to buy properties – also sometimes referred to as mREITs);
- Hybrid REITs — combine the investment strategies of equity and mortgage REITs);
- Sector REITs — focus on a particular type of property, such as data centers. Sector REITs can be Equity, Mortgage, or Hybrid REITs. The marijuana industry has created the opportunity for a new sector REIT.
Investors seek out REITs in the hope of receiving steady dividends as a result of the obligation to distribute most of the REIT’s annual income. Additionally, REITs give investors the ability to buy into a portion of a managed assets pool— allowing exposure to the real estate sector without having to worry about managing properties.
Why Are Cannabis REITs in the News?
People are hearing more about cannabis REITs these days because marijuana companies are starved for capital and exploring all avenues of raising funds. Two possible ways for a marijuana company to raise funds are to enter into sale-leasebacks or real estate capital expansion transactions with a REIT.
- In a sale-leaseback transaction, a marijuana company sells its real estate to a REIT and then immediately leases back the property at an agreed-upon rate. This provides immediate funding to the marijuana company.
- Another common transaction is the real estate expansion loan. In these deals, which are pursued by mREITs and hybrid REITs, the REIT lends money to the marijuana company seeking to buy or build out its real estate. This transaction is mutually beneficial as the REIT makes money from the loan interest and the marijuana company can affordably finance its expansion.
Advantages of REITs
One advantage of utilizing a REIT is the cost of the capital. The cost of capital offered by REITs is, in many cases, superior to anything available on public or private equity markets. Faced with challenging fundraising conditions as of late, marijuana companies are pursuing the best available funding terms.
Another advantage of utilizing REITs is that managing a large portfolio of real estate assets may prove too burdensome for some marijuana companies. Not only does real estate typically fall outside the core competency of operators, but the demands placed on cannabis real estate can be particularly difficult due to the unique zoning and land use issues. Of course, merely working with a REIT will not solve many of these regulatory issues, but it may help alleviate some of the operational burdens.
Why Are Investors Interested in Cannabis REITs?
Investors show increasing interest in the cannabis industry due to the growth potential and high yields on invested capital. According to public filings from Subversive Real Estate Acquisition REIT LP, which cites broker research, cannabis REIT transactions are providing yields on invested capital in the range of approximately 11-18%. In addition to potentially high yields, despite recent headwinds in the capital markets, the marijuana industry remains poised for growth.
According to New Frontier Data, overall sales in the legalized marijuana industry may reach almost $30 billion by 2025, close to triple its $10.3 billion of sales in 2018. This growth will require additional physical locations, especially as additional states legalize marijuana.
We are at the cusp of a massive expansion in the regulated cannabis market. The 2020 election cycle saw voters in New Jersey, Montana, South Dakota, and Arizona approve adult-use legalization and voters in Mississippi approve medical cannabis. In 2021 alone, legislatures in New York, Virginia, and New Mexico legalized cannabis. And in Washington D.C., Senate leadership indicated that it will support a new federal legalization measure.
Who Are the Players in the World of Cannabis REITs?
As a newer industry, only a limited number of Sector REITs serve in the cannabis space. As the industry grows and expands geographically, additional REITs may emerge.
- Innovative Industrial Properties — Founded in December 2016, Innovative Industrial Properties is probably the best known and oldest publicly listed cannabis REIT (NYSE: IIPR). It focuses solely on the medical-use side of marijuana. Its portfolio of industry and greenhouse buildings is leased to medical-use growers across major US markets, including several multi-state operators. It is currently in the midst of a public offering to raise approximately $217 million.
- GreenAcreage Real Estate Corp. (Cresco Labs) — Last year, GreenAcreage Real Estate Corp. announced that it had raised approximately $141 million in a private offering. It has closed large sale-leaseback deals with Acreageand Cresco Labs.
- NewLake Capital Partners, Inc. — NewLake Capital Partners, Inc. announced in September 2019 a private placement of $85.5 million in preferred stock and that it intended to be taxed as a REIT once it met the IRS criteria. It also entered into a sale-leaseback transaction with Columbia Care.
- Treehouse Real Estate Investment Trust Inc. —Treehouse Real Estate Investment Trust Inc. was launched by MedMen Enterprises (which later sold its stake) and Stable Road Capital. It raised $133.5 million in a private offering in January 2019 and an additional$60.3 million in September 2019. In February 2019 Treehouse closed a sale-leaseback of three properties with MedMen for $18.4 million in proceeds.
- RealCanna Investment Trust — RealCanna Investment trust is a newly formed Canadian-based REIT. There is limited information about it available online.
- Freehold Properties, Inc. — Freehold Properties, Inc. is another newly formed privately held REIT, which focuses on specialized agricultural, industrial, and cannabis properties. It recently provided up to $28.75 million in real estate capital expansion funding to Revolution Global in Illinois.
- Inception REIT — Inception REIT is a privately held REIT sponsored by the Inception Companies. It has invested in the California cannabis market.
- Power REIT — Power REIT is a publicly-traded REIT (NYSE: PW) that is actively seeking to expand its cannabis holdings. Power currently owns two cannabis greenhouse properties in Southern Colorado.
- AFC Gamma — AFC Gamma is a publicly-traded REIT (NASDAQ: AFCG) that has recently raised $119 million in its IPO.
Unique Challenges for Cannabis REITs
Marijuana Is Still Federally Illegal
The first challenge that any cannabis REIT faces is understanding the federal illegality of all marijuana sales and possession in the United States. This illegality creates the risk of asset forfeiture, criminal charges, and very real issues associated with banking, absence of bankruptcy protection, possible exposure to Internal Revenue Code Section 280E and reputational risk (although in the authors’ opinions, this is ludicrous). Many in the industry view the risks of asset forfeiture and criminal charges as purely theoretical, at least with respect to businesses operating in compliance with state marijuana law. There have been enforcement actions against bad actors, but legitimate, state-law abiding businesses have been left alone by federal prosecutors since the second Obama administration.
For medical cannabis operations, there is additional protection beyond prosecutorial discretion. Since 2015, Congress has used a rider provision in the Consolidated Appropriations Acts (currently the Joyce Amendment, but previously called the Rohrabacher-Blumenauer Amendment, and before that the Rohrabacher-Farr Amendment) to prevent the federal government from using congressionally appropriated funds to enforce federal cannabis laws against state-compliant actors in jurisdictions that have legalized medical cannabis and cannabis-related activities.
The black letter law, however, has not changed. Landlords could, theoretically, be criminally charged or have their assets seized, or both. The Controlled Substances Act (CSA) makes it a crime to lease or rent any place for the purpose of manufacturing, distributing, or using a controlled substance. In addition, it is illegal to aid or abet violations of the CSA, or to conspire or attempt to engage in such activities. And real property used to violate the CSA is subject to asset forfeiture (you can thank the “Crack House” Statute for this).
Federal illegality also creates a risk of potential private Racketeer Influenced Corrupt Organizations Act (RICO) claims. The recent era of marijuana legalization has seen neighboring property owners bring civil suits under RICO alleging the market value of their property has declined because of the marijuana operations occurring nearby. In addition to the criminal penalties under RICO, the statute creates a private right of action for anyone “injured in his business or property” because of a RICO violation. Under RICO, if at least two predicate crimes are committed, this constitutes a “pattern” and, therefore, a RICO violation. While RICO was intended to provide an avenue to prosecute organized crime, its list of predicate crimes includes dealing in a controlled substance and money laundering – which would pick up state-compliant marijuana operations. A successful civil RICO suit entitles a plaintiff to treble damages. Some of these cases have been dismissed, some have settled, and others have failed due to an inability to prove damages. Nevertheless, the legal threat to property owners remains.
Internal Revenue Code Section 280E prohibits anyone trafficking in controlled substances from deducting ordinary and necessary business expenses. This code section has plagued marijuana companies for years. To date, landlords have avoided 280E exposure, but the IRS has indicated its intention to expand the application of Code Section 280E to other cannabis-related activities, which could include landowners.
The Three Cannabis Industry Plagues: Banking, Insurance, and Bankruptcy
Moving into the realm of practical issues that are frequently present, marijuana landlords are faced with real challenges involving banking, insurance, bankruptcy, and reputational risk. An issue that currently plagues the industry, some banks may refuse to work with marijuana landlords or could close an account without notice if it later changes its mind. Insurance, including title insurance, can be difficult to obtain, expensive, may contain exclusions regarding the CSA, and may be subject to very low policy limits. Additionally, Federal bankruptcy protection is very likely not currently available for marijuana landlords. And, while it is disappearing rapidly, some slow-learners still harbor concerns about marijuana legalization and those involved in it— which may be something landlords care about.
Importance of Vetting Tenants
As noted above, the absence of federal prosecution only applies to state-legal businesses. Federal and state prosecutions of illegal marijuana businesses are ongoing. While charges are not frequently brought against landlords, if the tenant business owners are arrested or otherwise forced to stop operating their business, this would have a negative financial impact on the REIT. To reduce this risk, REITs should spend the time to vet their potential and existing tenants. Fortunately, some of this work can be outsourced to state and local regulators. Landlords can request copies of licenses and, in some states, confirm the status of those licenses online. Other states may permit verification of licenses by the regulators, with the permission of the licensed business. Full verification of a tenant’s compliance, however, does involve more detailed legal due diligence.
What If the Tenant Loses Its License?
The next major challenge for deals involving REITs builds on the threat of criminal enforcement discussed in the preceding paragraph. It’s not just bad actors who are subject to criminal sanctions. In the marijuana industry, good and bad actors must contend with a challenging and rapidly evolving regulatory environment. If its tenants are unable to keep their licenses and businesses in good standing with their applicable regulators, then the REIT may soon see itself holding property with a bankrupt tenant. And because each license tends to be tied to a specific location, it may be difficult or impossible to move in a replacement tenant. The universe of replacements is also not particularly large— a facility specifically built for the purpose of growing marijuana indoors, especially a large one, is something only a small number of businesses are interested in.
Real Estate Location and Zoning Challenges
Adding and financing new marijuana real estate locations presents yet another challenge. Many states have laws that allow localities to prohibit marijuana business, even when those activities have been legalized at the state level. The California Supreme Court has upheld many cities’ right to ban medical marijuana dispensaries, and, under corresponding adult-use regulations, municipalities have the explicit right to prohibit the presence of such businesses. Two-thirds of California municipalities now prohibit adult-use marijuana businesses. Likewise in Colorado, where state law permits a city or township to ban marijuana businesses, the geographical majority of the state has banned both adult-use and medical marijuana. Maps of both states will show huge swaths of land that are off-limits to marijuana operators.
Once an appropriate locality has been found, zoning presents an additional hurdle. Localities vary in how they address marijuana zoning issues, but it is common to see licensed businesses restricted to zones approximating their intended use (e.g., an infused product facility may be restricted to light manufacturing zones). On top of these typical restrictions, there may be additional zoning requirements for marijuana operations (e.g., certain districts may be specifically off-limits for marijuana).
Sensitive use setbacks present an especially difficult issue and vary between states and localities. For example, under California state law, all marijuana licensed premises must be at least 600 feet away from any K-12 schools, daycares, and youth centers, in existence at the time the license is issued. Nothing restricts localities from creating even more stringent setbacks. Los Angeles, for example, goes beyond the state regulations and requires marijuana businesses to remain at least 700 feet from schools, libraries, treatment facilities, and daycares. An incorrectly located facility would be subject to sanctions and could become unusable. Finding a new facility or expanding an existing facility would then become a headache.
Specific Contract Protections
Finally, there will be additional work needed to ensure the REIT is fully protected from a contractual standpoint. Leases need to be drafted to specifically account for the nature of the tenant’s activities. For example, landlords typically insist on a mechanism in the lease requiring them to be informed of any material changes in the tenant’s licensure status. Other industry-specific lease provisions that should be considered include:
- The ability to audit the tenant to confirm regulatory compliance
- The right to remove a tenant if regulatory issues arise
- The right to inspect the premises (subject to issues mentioned below)
- Odor and waste removal issues
- A prohibition on public consumption
- Carve-outs related to federal illegality
- Industry-specific indemnity provisions
Other lease considerations need to be evaluated in terms of the specific location of the marijuana business, as state and local regulations may dictate certain terms. While a risky idea for several reasons, participation rent, in many states, will deem the landlord an owner of the marijuana license — potentially necessitating a formal change of control process and background checks. Similarly, the right to inspect the premises may be subject to restrictions, as many states require all persons on a licensed premise to be licensed or to be supervised by someone holding a license.
The above issues pertain to sale-leaseback transactions. The real estate financing context presents additional issues. Collateralization of marijuana-specific assets – state and local licenses, marijuana, and marijuana products – is a new and evolving area. It may not be possible to secure a loan with these valuable assets of a marijuana company, depending on the states of operation. And even taking control of real property can potentially raise marijuana regulatory issues if marijuana or marijuana product is present on the premises.
The Future of Cannabis REITs
In the years to come, “cannabis REIT” will likely become a more familiar term throughout the industry. As more states legalize marijuana, the cannabis industry will grow— and all of those newly-created businesses will need funding and real estate for their operations. Cannabis REITs offer not only a good path for marijuana businesses to acquire new capital, but also give investors a way to dip their toes into the cannabis industry.