California Cannabis Leasing: Landlord Pitfalls

We’ve written previously about some common issues landlords run into when leasing to cannabis businesses (see links at the bottom of this article). Now that we’ve seen almost a year’s worth of emergency regulations, and the state has released its proposed final regulations, we’ve also seen a variety of cannabis leasing issues crop up. Here are a few of the most common ones.

Insurance

This is a frequent problem. Sometimes it’s an issue with the landlord’s current carrier being no longer willing to provide coverage, or a questions of how to pass the increased cost of premiums on to the tenant if coverage is actually available. Or sometimes it’s about the tenant’s inability to obtain reasonably priced coverage with sufficient policy limits and necessary endorsements. But more often than not, insurance presents a problem for one or both parties. Fortunately, insurance is becoming more available and reasonably priced as more admitted carriers join the market. There are different strategies suitable for different insurance-related problems, but some examples have been building a termination contingency into the lease for landlord’s inability to obtain or maintain coverage on the building, or for tenant’s failure to obtain or maintain its required policies. Generally in cannabis leases, the cost of premiums gets passed directly onto the tenant, and in a multi-tenant building the increase will be allocated directly to the cannabis tenant. We do anticipate that insurance will become less of a problem as the market for providers continues to expand.

Federal and state enforcement actions

As we’ve also written previously, while federal enforcement is a concern both parties need to account for, state enforcement is the more pressing and predictable concern, especially now that both federal and state enforcement priorities are ostensibly aligned. The keys to accommodating enforcement concerns are: building early termination options into the lease; training indemnification obligations to enforcement event-related costs, damages, and claims; and including robust use restrictions in the lease. One solution has been to levy hefty increases in the security deposit to act as an indemnification bond, and to expand its use to act essentially as a landlord legal defense fund in the event the tenant’s noncompliance with the lease triggers an enforcement action.

Licensing

The easily obtainable temporary state cannabis license is a thing of the past: Now applicants must submit the full annual license application, which is far more robust and demanding. Similarly, it can take months for an applicant to obtain a conditional use permit in localities that require one, which is common. Understandably, neither landlord nor tenant will know quite how they feel about the tenancy–and how much they want to invest in tenant improvements–until there is more certainty on licensing. A common solution has been to build into the lease an anticipated licensing timeline with benchmark contingencies that allow the parties to evaluate progress and decide whether to terminate if there is not enough.

Security instruments

If a landlord’s property is financed, the note and deed of trust will often have terms requiring compliance with “all laws” (including federal), or prohibiting nuisances, or maintaining insurance coverage. A landlord’s compliance with those requirements can be jeopardized by a cannabis use on the premises, so the parties need to consider the possibility that landlord could be held in breach by the mortgagee, or would not be able to finance or refinance the property if needed. One solution to this problem has been to build in an early termination option for the landlord, but to also provide the tenant the option of securing or providing alternative financing, or paying the difference in interest rate between the landlord’s traditional loan and a hard-money loan.

Payment

Cannabis tenants are forced to deal mostly in cash because of federal banking regulations, and would love to be able to pay their rent the same way. Landlords should resist the temptation, and prohibit the tenant from paying in cash. Right now there really isn’t a great solution for this problem, except for landlords to make sure it’s not their problem. There are a handful of banks that serve cannabis businesses, and it’s the tenant’s responsibility to find them.

Subletting, multi-tenant buildings, and premises modification

Often, a cannabis tenant will be applying for multiple types of permits and licenses, with the intent of conducting several separate operations on site. For example, indoor cultivation, manufacturing, and distribution businesses all owned by tenant and operated under separate licenses under the same roof. Under current proposed regulations, this is possible, but licensed premises must remain separated by distinct barriers and locked doors. This means that where one or more cannabis tenants are operating on the same site (often a former warehouse) tenant improvements will be needed (often they already are due to a required increase in utilities capacity), and strict protocols must be followed regarding access and security. The parties should anticipate these issues with a through regulatory review during the leasing process and crafting of the tenant work letter, and part of that can also include requiring the tenant to submit its security and access plan to the landlord for approval, as it already will have to be submitted to the state (and often the local government as well).

One thing we have not noticed since this time last year is a cool-down in real estate purchases and leasing. Because of the limited number of jurisdictions allowing cannabis uses, and the even more limited number with accessible permitting regimes and attractive taxation, real estate in suitable locales has stayed expensive and competitive. Now that California is seriously considering the prospect of a public bank for cannabis, it will be interesting to see if real estate prices ease off at all as more jurisdictions open for business.

For more on California cannabis leasing, check out the following: