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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2018

Cultivate Cannabis

Spot and structure deals to capitalize on the growing legal-marijuana industry

Cultivate Cannabis

If you missed big news from the last election cycle, you should know that cannabis is now legal for both medical and recreational use in seven U.S. states, as well as Washington D.C. Those seven states include California — the sixth-largest economy in the world by some measures. Collectively, the markets represent about 24 percent of the nation’s gross domestic product.

Within the rapidly growing legal-cannabis market, there are real estate financing needs that are not being met. Over the next two to five years, the market will present extremely interesting opportunities for commercial mortgage brokers who are willing to look at the industry’s prospects through the lens of hard-asset investments.

Across the U.S., cannabis investors will find a combined market that reached $6.7 billion in sales in 2016 and is projected to grow to $50 billion by 2026, a meaningful seven-fold increase within one decade. Additionally, Maine and Vermont are poised to join the group of states with legal medical and recreational cannabis. Maine voters approved recreational use in 2016 but the state Legislature has delayed a vote to implement a retail-sales and regulation system. Vermont’s law, meanwhile, is set to go into effect July 1 of this year.

Institutional investors remain wary of federal policy on cannabis and have largely opted out of financing this industry, while angel investors lack the specialized knowledge required to meet the industry’s unique real estate financing needs.

Along with the overall lack of investors, there also has been tremendous hubris within the legal-cannabis financing industry. This includes oversized valuations; large funding rounds, or securities offerings, for companies that have never sold a product; and many commercial mortgage brokers who do not perform the same due diligence on cannabis deals as they would for potential investments in any other industry.

Fundamental perspectives

Before you can identify appropriate deals within the cannabis industry, you first have to remove much of the industry’s mystique that has been created by the regulatory and legal environments surrounding the product. As these environments soften, the cannabis industry will likely develop into a much more standard commodity market than we see today. This evolution will produce two key changes with broad implications to keep in mind when evaluating any cannabis-related deal.

First, expect a substantial price drop for the product. Cannabis has a lot in common with most fruits, vegetables and spices. Unlike mature commodity produce, however, cannabis commands a much higher price. You do not see tomatoes selling for $1,000 a pound. The closest price analog would be truffles, but their high price derives from the challenges of bringing truffles to market. Cannabis, by contrast, can be grown by someone in their backyard.

When you apply a standard economic perspective to cannabis, you see that price compression will inevitably impact the marketplace. Practically speaking, this means reviewing the budget for every deal to make sure it accounts for a future inflection point where prices decrease.

Second, expect a shift in the face of the industry. The cannabis industry may evolve similarly to the post-Prohibition alcohol industry. When you look at the makeup of the roughly $220 billion alcoholic-beverage industry, you don’t see a lot of “two-guys-in-a-garage” business owners who have made it. Instead, you see a lot of large, vertically integrated players covering everything from production to distribution.

The cannabis industry is ripe for similar, significant consolidation over time. So, when you review a deal, pay careful attention to how the underlying business plans to scale and what size its operation aspires to reach.

Five years from now, the cannabis industry will look very different than it does today, with real implications for which deals you should champion and which you should not. Knowing this will increase your chances of picking the right deals and succeeding as a mortgage broker within the industry.

Fundamental qualities

The primary quality mortgage brokers must leverage for success in the cannabis industry is simple: They must maintain the discipline to consistently apply the same basic underwriting process to a cannabis deal that they would apply to any other deal.

This discipline is rare in the cannabis industry. There is something about a hot, new industry that makes people believe the standard rules of investments do not apply. With every deal, no matter how good it looks, do your homework and approach it like you would any serious business opportunity in any other industry. Learn the market and its key drivers. Track how the market is evolving. And don’t get too caught up in deals that look too good to be true. They likely are.

When you apply a standard economic perspective to cannabis, you see that price compression will inevitably impact the marketplace. 

Know the market well enough to find people to successfully assist with financing. In the cannabis world, many people seek — and receive — funding who would not receive it if they attempted to open a business in any other industry. But there also are many sophisticated, proven businesspeople who are either established within the industry, or now entering it, who are looking to build a proper business. Invest in them.

Maintain your discipline about which businesses you get behind. It may sound simplistic, but there are both great success stories and horror stories in cannabis financing. The horror stories occur when brokers and investors forget these fundamentals or believe they don’t apply to the cannabis industry. The great success stories occur when brokers and investors maintain their discipline and treat the cannabis industry like any other — and that begins with choosing the correct market for a deal.

Evaluating markets

Unfortunately, there is no one-size-fits-all rule to evaluate markets for cannabis deals, since cannabis is individually regulated by each state. Different states have different products, different prices for the same products and different regulatory regimes. These regulations are fluid and it’s critical to stay on top of them.

The most fluid elements of regulation are, of course, which states have made cannabis legal, which states have not and which are likely to make it legal in the future. The deals you will look for will hinge on the current regulatory maturity of the market you’re considering.

In a market like Colorado, where cannabis has been legalized for a relatively long time, the greatest opportunities exist in long-term growth via scale and consolidation. In a market like New York, however, where cannabis is not yet legal but where regulations are likely to change soon, you will see a lot of entrepreneurial activity and the greater investment opportunities may reside in short-term growth.

At the individual market level, business dynamics can vary widely, depending on market demographics — different demographics prefer different products — and competition. Pay attention to how many licenses are given to a market you are considering entering.

In some markets, there is only one legal operation within a 20-mile radius. In other markets, there might be eight businesses in direct competition with each other. The industry has reached a point where a single store closure can dramatically change the structure of every other deal in that market. Without this information, any deal you put together will be woefully incomplete.

Structuring deals

The importance of treating cannabis ventures like deals in any other industry can’t be overstated, but it is true there are a few specific challenges and opportunities to keep in mind when seeking or structuring financing for this product.

As a general rule, even cannabis-friendly investors will approach deals from this industry with added caution. Investors want to see well-capitalized companies that have enough financial backing to meet the terms of the loan. And to close cannabis-property deals, you will have to provide more than just the standard documentation. This industry requires additional underwriting.

Even with strong borrowers, the potential for a federal crackdown on legal cannabis dramatically changes the risk-adjusted profile of any deal within the cannabis industry, in particular when you seek financing for improvements. You may receive a deal for a $6 million warehouse build-out and the numbers work when cannabis sells for $79 an ounce. If the business closes, however, there is no other product to store in that warehouse that would sell at those prices and make those numbers work.

This concern extends to every deal in the cannabis industry. You might have a very interesting business infrastructure, but if the underlying economics won’t work for any other product, then a standard investment will be unsustainable. With property-improvement deals, lenders are careful about how much financing they provide and what their exposure is. A lender may finance up to 75 percent of the acquisition costs, but may require additional collateral, such as another piece of real estate, personal guarantees or other assets, to close the deal.

Finally, when putting together a deal, commercial mortgage brokers should look for interest rates and terms similar to where the bridge-finance industry as a whole is at right now — somewhere between 10 percent to 15 percent interest, with loan-to-value ratios up to 70 percent or 80 percent for qualified borrowers.

•  •  •

In summation, the cannabis industry may be new, but the best ways to capitalize on the opportunities it brings are not new. Learn the key market drivers. Understand the role of regulation within the industry. Protect against the industry’s unique risks. Only partner with real business people who take the opportunity as seriously as you do. And, rather than spending your time attempting to convince people with capital, but against cannabis, to invest in this market, focus on talking to the industry players who are open to it.


 


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