The United States’ retail cannabis industry continues exploding, and it doesn’t show any signs of slowing down. These numbers are guaranteed to change after this Tuesday’s election, but as of October 2022, 37 states have legalized some form of medical cannabis, and 19 have legalized the substance for recreational use. Now, only 3 states remain with no cannabis access laws on the books. Retail cannabis sales in the U.S. are projected to exceed $33 billion by the end of 2022. As the industry continues to boom, retail landlords have increased opportunities to diversify their retail spaces by leasing to cannabis tenants. However, with these new opportunities come unique challenges and important considerations landlords should address as they prepare to lease to tenants in this new sector of the market.
1. Prohibited Use Restrictions
First, retail landlords should investigate whether there are restrictions specific to their property that would prevent them from renting to a cannabis tenant. Prohibited use restrictions can be found in a variety of agreements and prevent a piece of property from operating for a certain purpose. Two common prohibited use restrictions that could pose issues for cannabis tenants are:
a) Noxious Use Restrictions—these restrictions typically prevent uses such as “any use that emits an obnoxious odor that can be smelled outside of any building” or “any use which violates any law, code, ordinance or regulation”; and
b) Head Shop Restrictions—these restrictions prevent a landlord from leasing part of the retail property to any establishment selling or exhibiting drug-related paraphernalia or products.
Landlords will want to diligently review their leases with other tenants in the center to ensure that existing restrictive covenants will not prevent them from leasing to a cannabis tenant. In addition, landlords should review any reciprocal easement agreements, covenant, conditions or restriction agreements, and any other restrictive covenants recorded against their retail centers. If any of the former restricts a landlord from leasing to a cannabis tenant, the landlord might consider negotiating amendments to delete the applicable restriction provisions. Otherwise, tenants in the center may be able to enforce a prohibited use restriction against the cannabis tenant and/or the landlord.
2. Zoning Laws & Regulations
Next, landlords should review local zoning laws and regulations to ensure that cannabis businesses are legal in their particular jurisdiction. Even in states that have legalized cannabis, individual counties and cities might restrict the particular areas where cannabis businesses can operate. For example, California law allows individual jurisdictions to decide whether to permit cannabis businesses at all. Many jurisdictions also have zoning ordinances limiting the number of cannabis businesses in a particular area or requiring a cannabis business to keep a minimum distance from schools, daycares, other dispensaries, or alcohol or drug treatment facilities. Lastly, some jurisdictions restrict cannabis businesses to cultivation but not retail, and vice versa. A landlord will want to ensure that their retail center is located in a jurisdiction that permits the proposed cannabis tenant’s business activities.
In addition, many jurisdictions require retail property owners to apply for conditional use permits before allowing a tenant to manufacture or distribute cannabis onsite. Landlords should be familiar with any required permits before entering a lease with a cannabis tenant, as the process of obtaining a conditional use permit can be quite involved. To obtain a conditional use permit, a landlord must typically petition the relevant municipality for permission, attend a public hearing, and prove that their lease would meet all the applicable standards and conditions imposed by the relevant zoning ordinance.
3. Tenants’ Financial Limitations
Landlords should be aware that cannabis tenants confront unique financial barriers to operating their businesses. Because marijuana is still federally classified as a Schedule I controlled substance, and major banks are required to comply with federal law, cannabis retailers generally cannot obtain traditional business loans. Some cannabis companies rely on loans from state credit unions and small local banks. However, even these financial instructions are hesitant to issue such loans because of the Money Laundering Control Act of 1986, which deems it a federal crime to engage in financial transactions with proceeds generated from certain unlawful activities. Consequently, cannabis companies tend to be “cash-heavy,” dealing primarily in cash and non-cash alternatives. Landlords should be prepared to accept monthly rental payments in cash. They should also recognize that most cannabis tenants will not have long financial histories, making it difficult to predict a tenant’s ability to meet financial obligations under the lease. To address this uncertainty, landlords should consider requiring cannabis tenants to provide a third-party guaranty, ensuring that a third party will pay the tenant’s rent if the tenant becomes unable to do so.
These financial limitations could also impact a cannabis tenant’s ability to build out their lease space at the beginning of the lease term. To address this issue, landlords might consider granting cannabis tenants higher improvement allowances in exchange for increased rent over the course of the term. This arrangement would give a cannabis tenant the capital they need to build out their store while providing for the landlord’s recoupment of the cost over time.
The future of this issue is subject to change as Senate approval is pending on the Safe Banking Act, a law that would prohibit federal regulators from taking punitive measures against financial institutions that service cannabis businesses.
Landlords should employ extra safety measures in spaces occupied by cannabis tenants. Because, as mentioned above, cannabis companies are cash-heavy and carry large quantities of a federally-illegal substance, they are unfortunately targets of theft. Certain states also impose stricter safety requirements on cannabis retailers. For example, Colorado requires cannabis retailers to use commercial-grade locks, an alarm system, and a continuous monitoring system either through cameras or security guards. Landlords should be conscious of the heightened risks associated with leasing to such tenants, familiarize themselves with their respective state’s requirements, and recognize that the necessary safety measures will likely result in greater expense to cannabis tenants as they build out their retail spaces. Again, because of cannabis tenants’ lack of access to traditional capital, landlords might consider giving the tenants larger improvement allowances so they can properly secure their retail spaces.
In addition, for a landlord’s protection, the landlord should consider including a disclaimer in the cannabis tenant’s lease stating that the landlord is not responsible for the admission of any person into the building or for any resulting criminal acts.
5. Compliance with Third Parties
Marijuana’s classification as a federally controlled substance also poses challenges for landlords to navigate with third parties such as mortgage lenders and insurance providers. First, most standard mortgage contracts contain provisions requiring borrowers to comply with all applicable laws, rules, and regulations. Landlords with mortgaged retail centers should consult with their mortgage lenders to ensure that leasing to a cannabis tenant will not lead to a default on their mortgage. Some lenders require landlords to purchase special insurance to cover cannabis tenants and/or to add a rider to their mortgage insurance policy that specifically covers risks associated with leasing to cannabis tenants. Landlords should consider including a term in their leases with cannabis tenants that allows the landlord to terminate the lease early without penalty in the event of a threatened mortgage default.
In addition, landlords should consult with their insurance companies to ensure that their policies will extend to a cannabis business. It is not uncommon for insurance companies to deny a claim arising out of a cannabis business because the claim is based on a federally-illegal use. More harshly, some insurance companies will even void a landlord’s insurance coverage altogether.
Because additional insurance policies and riders lead to increased costs, landlords should consider raising a cannabis tenant’s rent accordingly to offset the expense.
6. Landlord Protections
Due to the highly regulated nature of the cannabis industry and the conflict between applicable state and federal laws, landlords should take precautions in their leases to establish clear boundaries between themselves and a cannabis tenant’s business operations.
First, landlords should include an escape clause in their leases stating that the parties acknowledge the tenant’s use of the leased premises is violative of federal law and providing that the landlord can terminate the lease early in certain situations, for example— (a) if there are any threats from a governmental authority for criminal or civil penalties, (b) if the tenant is at risk for investigation or prosecution by the federal government, (c) if state or local laws change making the business illegal, or (d) if the tenant violates applicable cannabis laws or loses any of its necessary licenses or permits.
Second, landlords should include an automatic termination clause in their leases providing that the lease will automatically terminate early if the federal government seizes the premises leased by the cannabis tenant.
Third, landlords should opt for fixed rent rather than percentage rent. A percentage rent agreement with a cannabis tenant could put the landlord in jeopardy of being considered part of the cannabis business. Even absent equity ownership, a landlord who receives a defined share of a cannabis tenant’s revenue is considered to have an owner’s interest in the business. Landlords should use fixed rent provisions to avoid the risks associated with being involved in a cannabis business, such as a mortgage default (as mentioned above).
Fourth, landlords should make clear in their leases that they will not take possession of a tenant’s inventory upon the tenant’s default. Although possession would be a typical remedy in a retail lease, given the potentially criminal nature of cannabis possession, retail landlords should explicitly state that they will pursue alternative remedies upon a tenant’s default.
Fifth, while standard leases include compliance provisions requiring tenants to comply with all laws applicable to their operations during the lease, landlords should consider drafting federal law carveouts to these provisions. Leases should explicitly state that cannabis tenants are to remain in compliance with all state and local laws while simultaneously acknowledging that cannabis tenants will not comply with certain federal laws, such as the Racketeer Influenced and Corrupt Organizations Act of 1970, the Controlled Substances Act, and anti-money laundering laws.
Finally, landlords should add an indemnification provision to their leases, requiring a cannabis tenant to indemnify them for any damages incurred as a result of any federal or state enforcement action in connection with the tenant’s cannabis business.
7. Landlord’s Access & Inspection Rights
Standard retail lease forms typically grant a landlord unrestricted access to the leased premises for purposes of inspections, repairs, and environmental testing. However, such a provision in a lease with a cannabis tenant could cause the tenant to violate local cannabis laws, such as California’s Medicinal and Adult Use Cannabis Regulation Safety Act. The necessary considerations in this area parallel those that have come into play recently as medical office users are migrating to retail centers. Landlords who lease retail space to medical office users know they may not have unrestricted access to protected areas containing items like medical files with confidential health care information or medication storage areas. Likewise, many states require cannabis businesses to have “limited access areas” to restrict who can access cannabis products and to protect the confidential health care information of medicinal cannabis users. Thus, landlords should familiarize themselves with local laws to ensure that their leases allow them sufficient access to the premises while still complying with all applicable laws.
8. Licensing Contingencies
Cannabis business license requirements can vary significantly from state to state and even county to county. Many jurisdictions require an applicant for a cannabis business license to secure a location for their store before applying for a business license. Like restaurant tenants, whose leases are typically contingent upon their successful receipt of a liquor license, cannabis tenants will likely negotiate leases that are contingent upon their successfully obtaining a cannabis business license. As such, landlords should familiarize themselves with local licensing laws so they know when a lease contingency is appropriate and for how long it should last.
9. Permitted Use Specificity
As with any retail lease, landlords should narrowly tailor the tenant’s permitted uses of the premises by specifically itemizing which activities are permitted and which are prohibited. Because cannabis law is continually evolving, activities that are still illegal in some areas could become legal down the road. Landlords should avoid permitting cannabis tenants to use the leased premises for “any lawful purpose,” as an open-ended provision could eventually allow the tenant to participate in activities not contemplated by the landlord, such as smoking and consuming cannabis on the premises. With regard to cannabis dispensaries, landlords might consider limiting the permitted use to something like “retail sale for off-premises consumption only.”
Husch Blackwell has experience working with retail landlords on how to lease to cannabis tenants with an eye toward more intense forthcoming regulation. Our Cannabis and Real Estate & Development lawyers have the expertise to assist landlords considering diversifying their retail centers by leasing to cannabis tenants. Contact Andrew Hodgson, Marshall Custer, or your Husch Blackwell attorney.