The cannabis industry continues to expand across the United States as more and more states legalize cannabis on various levels from limited medicinal to adult recreational use.
As the industry develops, the demand for financing grows with it. Since cannabis is still illegal under Federal law, nationally chartered banks and credit unions and other institutional sources of capital have refused to provide desperately needed credit to cannabis related businesses. In the absence of conventional funding sources, regional banks, state-chartered credit unions, and private lenders have readily answered the call from cannabis businesses.
The requests for capital come not only from the actual cannabis businesses, but also from the property owners that are leasing to them. Due to challenges related to transferability of licenses and the continued Federal illegality of cannabis, most cannabis-friendly lenders have focused on taking real estate as collateral for their loans and have avoided taking a collateral interest in the business itself. Even so, cannabis loans that are secured by real property still present unique considerations to anyone evaluating a prospective loan.
Three questions that every lender must ask when thinking of making a cannabis loan are:
- Are all necessary licenses and permits in place?
- Will a title company issue a lender’s title policy?
- What is the exit strategy?
1. Are All Necessary Licenses and Permits in Place?
The threshold question that needs to be answered when looking at a cannabis loan is whether the cannabis business can do what it is doing at the location in question. Therefore, there are really two questions to answer.
Is the Real Estate in an Appropriate Location?
First, the real estate must be the appropriate location to legally operate the subject cannabis business. In many cities, since it is unlikely that a parcel is zoned for cannabis cultivation, manufacture, or distribution, a conditional use permit or zoning variance is needed prior to the operation of the cannabis business at the subject property. The actual use must be consistent with the permit or variance. If the cannabis use does not match the approved activity at the property, this discrepancy must be addressed by either passing on the loan or requiring that the current noncompliant activity immediately cease and not recommence until proper authorization is obtained.
Is the Operator Licensed?
Second, assuming the property can be used for the intended cannabis related business, the operator must be licensed. It is important to note that, depending on the licensing scheme of a given state, there could be licensing requirements at the state, county, and city level. If the cannabis license is not in good standing, the cannabis business should not be operating at the property until it has been returned to good standing. If the license application is pending, a loan can still be extended to the borrower, but there must be strong provisions in the loan documents prohibiting the operation of a cannabis related business unless and until proof of proper licensing has been provided to the lender.
2. Will a Title Company Issue a Lender’s Title Policy?
Since extending a loan without obtaining a lender’s policy of title insurance is ill advised, a lender contemplating extending cannabis loans must know whether or not such policy is available in the location where the property sits. In some states you can find a title company that will insure across the entire state, while in other states the availability of coverage for a cannabis loan will vary by region or county. Finding a title company that will issue a policy covering a property where a cannabis business is operated can be difficult since none of the national title insurers will extend a title policy if it knows the property is being used for a cannabis related purpose, even if that purpose is legal under state law. The good news is that in most states where cannabis reform has taken hold, a local or regional insurer has stepped in and started issuing policies.
The “don’t ask, don’t tell” practice when it comes to requesting title insurance is a risky venture as we have been informed by multiple title companies that they view the cannabis operation as a material fact that would have led to the company not issuing a policy. The title company will then use this omission of material fact as grounds to void the title policy.
It is also important to understand any limitations on the coverage offered. Some title companies will only issue a CLTA policy or an ALTA policy with the western regional exceptions. In addition, there will more than likely be cannabis-specific exceptions included in the policy. Most companies that will insure a cannabis transaction will outline the coverage that is available upon request. Before accepting any changes to the form of policy or exceptions to the policy, make sure you review with counsel to ensure you understand how the policy will differ from standard policies evidencing loans secured by real estate, and that the changes requested by the title company are actually in alignment with generally accepted practices related to cannabis loans.
3. What is the Exit Strategy?
Unlike many private loans which are short-term in nature and meant to serve as a temporary solution until the borrower can obtain a bank loan, take-out options can be limited due to the current unavailability of conventional funding for cannabis related loans. Therefore, a lender making a cannabis related real estate loan must be conscious that the borrower may have difficulty refinancing. If the borrower ends up performing well over the life of a loan, the lack of take-out options can benefit a lender that is willing to renew. Conversely, if the borrower presents problems, the only option could be foreclosure if there are no other refinancing options available. In instances where the borrower is leasing to a cannabis tenant, a poorly performing borrower is often an indication of an unsuccessful tenant that is not current on rent. A foreclosure sale of the real property will often mean the loss of the cannabis tenant and its business and thus devalue the property. The best way to guard against this prospect is to consider the value of the property without the cannabis business when underwriting the loan, as this will often be the most likely outcome of a foreclosure.
Conclusion
Because cannabis is still federally illegal and cannabis related finance is relatively new compared to other types of loans, it can be a scary prospect. Despite the unique challenges presented by cannabis loans, lenders that take the time to understand the industry can find a lot of opportunity with a low saturation of competing capital. Knowing and understanding the risks of making cannabis related loans will also lead to solutions on how to mitigate against those risks. It is critical for any lender considering making cannabis related real estate loans to work with others that are experienced in navigating these special loans.
