Leasing to California Cannabis Tenants
Leasing commercial real estate to a cannabis business in California can be a great opportunity for the right lessor, but it comes with significant risks. It’s important for lessors to understand these risks before entering into a lease with a cannabis business. This guide examines various questions our cannabis landlord clients frequently ask my law firm’s attorneys regarding leasing California properties to cannabis businesses.
1. What Risks Do I Face as a Commercial Landlord If I Decide to Rent to a Cannabis Tenant?
One of the most significant issues lessors must understand is that cannabis is still illegal. While California permits cannabis sales, cannabis remains a schedule I controlled substance under federal law, meaning the US treats it the same way as heroin. And while cannabis may soon be rescheduled to schedule III, that won’t make it federally legal.
This discrepancy exposes lessors to potential legal repercussions, from potential civil asset forfeiture to automatic and in some cases incurable defaults under mortgage contracts. While these risks cannot be completely eliminated, there are some risk-mitigation strategies that sophisticated cannabis lessors routinely use, including:
Insisting on Strict Compliance with State Regulations: Lessors can reduce a huge amount of legal risks by ensuring that tenants adhere to all state and local cannabis laws, including by obtaining necessary licenses and permits. Some lessors opt to undertake regular audits or inspections, although many lessors don’t know what to look for any don’t want to be involved on a regular basis – which is where a good cannabis attorney can be immensely beneficial.
Including Provisions for Lease Termination: Good leases always enumerate ways for the lessor to terminate the lease. Many of these “standard” termination provisions fail to address cannabis-specific risks. A good cannabis lease will include cannabis-specific termination provisions, such as by allowing early termination if a tenant engages in cannabis activity before a permit is awarded, if there are significant changes in federal law, or if enforcement actions occur.
Addressing Potential Risks in the Lease Agreement: A good cannabis lease will also address risks specific to cannabis leasing, including zoning regulations, compliance requirements, and so one. I address many of these issues later in this post.
2. My Prospective Tenant Says She Needs a Signed Lease Before She Can Obtain a Permit to Operate, But I Don’t Want Her to Move In Without a Permit. How Can I Protect Myself?
Obtaining a cannabis business permit often requires a signed lease, creating a dilemma for landlords. But, it is not insurmountable. Here are some common strategies we see cannabis lessors take:
Requiring permits before lease effectiveness: Lessors often mitigate these risks by prohibiting their tenant from operating prior to obtaining a permit. In some cases, a lease will be signed effective as of date X but not have a “commencement date” until the tenant is permitted. This will ensure that a tenant doesn’t have a right to use or in some cases even fully access the premises, even with a signed lease.
Incentivizing speedy licensing: Cannabis tenants often ask for reduced rent while seeking licensure, or for having an early termination right if they are unable to secure licensure within a specific time frame. In these cases, it’s in the lessor’s best interest to ensure that the tenant aggressively pursues licensure. So, a smart lessor will negotiate clear time frames. These lessors will also require the tenant to provide regular updates on permit applications — especially important if the lessor has rent-reduction provisions — so that they can make sure that the tenant is actually doing what it is supposed to be doing.
Clarifying Termination Rights: Tenant timing obligations and milestones are great, but if there is no penalty for failing to meet the milestones, they are effectively optional. Good leases will permit the lessor to terminate should the tenant fail to timely get permitted or achieve other permit-related milestones on time.
3. Will the Mortgage on My Building Be Affected By My Having a Cannabis Tenant?
Most commercial mortgage agreements include clauses restricting property use that violates federal law. Since cannabis remains illegal federally, this means that the lessor can automatically find themselves in default under their mortgage agreement. To address this, cannabis landlords often:
Review Mortgage Agreements Carefully: One of the first things a good cannabis attorney will recommend to a lessor is to review their mortgage documents for clauses prohibiting cannabis activities. Many cannabis lessors have absolutely no idea that these prohibitions exist and without proper consideration can really shoot themselves in the foot.
Consult Lender: If a mortgage contract contains anti-cannabis language, lessors often contact their lender to seek consent. Some lenders will consent, but many will not. If a lender won’t consent, and the lessor can’t pay off the loan or refinance immediately, the lease probably won’t work. We’ve seen plenty of cases where both parties invest time and money into lease negotiations only for the lessor to pull out at the last second after the lender says “no” to a cannabis tenant. Nobody wants to be in that position.
Explore Cannabis-Friendly Financing: If a lender won’t consent and a lessor doesn’t have cash to pay off the loan, the lessor may explore refinancing. Given that interest rates are high at the moment, and that financing options are pretty limited when it comes to cannabis businesses, this may not be a viable option for all lessors.
4. My Property Insurance Premiums Are Going to Increase Due to Cannabis Risks. Should I Pass This Cost Onto the Tenant?
Leasing to a cannabis tenant can lead to increased property insurance premiums due to the higher risk associated with cannabis operations. And, some insurers refuse to over coverage to cannabis-related ventures,. Here too, lessors available options:
Seeking Cannabis-Friendly Insurance: The first thing lessors must do is to see whether leasing to a cannabis business is likely to lead to coverage issues under their current policies. If so, there are plenty of brokers who specialize in procuring policies for cannabis-adjacent businesses like lessors.
Passing Costs Onto the Tenant: Many cannabis leases are structured as triple net, or (NNN) leases. In NNN leases, landlords pass their insurance, tax, and other costs on to their tenant. That way, even if the tenant’s use of the property leads to a policy increase, the tenant will be financially responsible for the increase.
Mandating that the Tenant Maintain Insurance: Any good lease will specify the types and amounts of insurance coverage required from the tenant. These policies commonly include things like general liability, property insurance, and additional coverage as needed. As with other provisions mentioned above, insurance provisions often need adjustment for cannabis-specific uses.
5. Is It a Problem if My Cannabis Tenant Wants to Sublease to Other Operators?
California and local regulations limit subleasing for licensed cannabis businesses. This means that once a tenant gets a license, the property cannot be further sublicensed. There are situations where one party leases a particular property with the intention of subleasing it to an operator, in which case, a sublease may be available. However, it’s important for lessors to understand what their tenant wants to do.
It’s also important to note that a good lease’s assignment provisions (which often go hand-in-hand with sublease provisions) usually consider a change in equity holders of the tenant to be an assignment that requires the lessor’s prior written approval.
With that in mind, lessors often mitigate assignment and sublease-related issues by clearly define approval requirements, notice periods, and conditions for subleasing and assignment, specifically as related to changes of ownership of the tenant, and by vetting any proposed sublessee to better ensure timely payment and compliance under their lease.
6. Zoning and Local Regulations
Understanding zoning laws and local regulations is crucial when leasing to cannabis businesses. Non-compliance can result in fines, operational shutdowns, or other legal issues, which in turn can affect the lessor. Lessors don’t want to be in a position where the tenant blames the lessor for misrepresentation of a zoning-type issue affecting the property. Lessors should at least have a minimal understanding of what local zoning regulations affect the property, and whether the property is in the right zone for the desired cannabis use. A good lessor is usually careful to disclaim any zoning-type of representations in their lease agreement.
7. What Should Go Into My Cannabis Lease?
A well-crafted lease agreement is essential for protecting the landlord’s interests in a cannabis tenancy. Some of the provisions we usually see in cannabis leases include:
Permitted Use Provision: These provisions outline the specific activities allowed on the property and disclaim everything else. A tenant who engages in non-permitted uses will be in default and the lessor can take action against them.
Odor Control Provision: These provisions impose requirements for odor control, such as ventilation systems and air filtration, to minimize disturbances to neighboring properties. This is a good way that the lessor can protect against things like nuisance litigation from neighbors – something that we have seen happen again and again, especially as it relates to cultivation.
Security Requirements: Cannabis businesses are often the targets of crimes. No lessor wants property damage, vandalism, or theft. So a good lease will include provisions for security measures, such as surveillance systems, alarm systems, and access controls, to enhance property security and prevent damage, vandalism, or theft.
Insurance Requirements and Termination Provisions: As mentioned, a good cannabis lease will specify the types and minimum amounts of insurance coverage required from the tenant, as well as the circumstances under which a lessor can terminate the lease.
8. Should I Use an Attorney Experienced with California Cannabis Leases?
Absolutely. Given the complex legal landscape surrounding cannabis, consulting with an attorney experienced in California cannabis leases will almost certainly save money and reduce risks.
An attorney experienced with California cannabis leases can provide tailored advice, draft comprehensive lease agreements, and protect the lessor’s interests in case of legal challenges. They understand the nuances of cannabis regulations, potential liabilities, and can help lessors navigate the complexities of leasing real estate to a cannabis business.
The post A Guide to Leasing to California Cannabis Tenants appeared first on Harris Sliwoski LLP.
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