Commercial Leases Involving Cannabis Businesses A Practical Guide for Landlords and Their Counsel, 0321 COBJ, Vol. 50, No. 3 Pg. 42

• Author: BY BEN LEONARD AND BRETT WILLIAMS
• Position: 50, 3 [Page 42]

50 Colo.Law. 42

Commercial Leases Involving Cannabis Businesses A Practical Guide for Landlords and Their Counsel

No. 50, No. 3 [Page 42]

Colorado Lawyer

March, 2021

REAL ESTATE LAW

BY BEN LEONARD AND BRETT WILLIAMS

As the cannabis industry continues to grow in Colorado, commercial landlords and their counsel will encounter tenants with cannabis-related businesses more frequently. This article addresses issues unique to these lease transactions and offers suggestions for structuring such leases to maintain regulatory compliance.

The prolific rise of the cannabis^[1] industry in Colorado over the past decade has had a pervasive effect on the industries that support it, including the commercial real estate industry. Real estate attorneys are increasingly encountering cannabis-related matters in their general practice, so it is critical that practitioners understand the state's legal frame work regulating cannabis and how their clients fit into it.

This article explores the cannabis legal landscape as it relates to commercial landlords in Colorado. It addresses factors landlords should consider before entering the cannabis space, offers suggestions for structuring lease provisions in the cannabis industry context, and discusses the potential impact of Internal Revenue Code (IRC) § 280E on property owners.^[2]

General Considerations for Landlords

Leasing to cannabis operators can benefit landlords, but before jumping in with both feet, real estate owners should weigh these benefits against the inherent challenges of such an arrangement.

Opportunities

Above all, landlords stand to benefit from charging a premium on rent. This is often justified by the increased risks the landlord assumes by leasing to a cannabis operator. It's also driven by supply and demand. Landlords can often charge a higher base rent where there's greater competition for properties that satisfy the licensing requirements. In Colorado, local jurisdictions can regulate the time, place, and manner of cannabis operators, so they may implement zoning and setback requirements unique to marijuana operations.^[3] For example, in Denver, in addition to complying with general zoning requirements, a dispensary may not be located within 1,000 feet of another dispensary, a school, an alcohol or drug treatment facility, or a childcare establishment.^[4] A property that satisfies all of these requirements will be attractive to cannabis tenants.

Further, depending on the local jurisdiction, the tenant may be required to make substantial improvements to the property to obtain its license, including bringing the property up to code and implementing security measures.^[5] Colorado cannabis licensees are also required by law to install on a licensed premises an alarm system and continuous monitoring, through the use of cameras and optional security personnel,^[6] and must use commercial grade locks.^[7] A landlord stands to benefit long into the future from such improvements to the property and security systems.

Challenges

Despite the attractions to the cannabis industry, cannabis-related leasing arrangements also present property owners with unique challenges. First and foremost, landowners should be aware that conventional lending is largely unavailable to the cannabis industry at the present time due to marijuana's status as a Schedule I drug under the federal Controlled Substances Act (C SA).^[8] Federal banking reform efforts to address this issue are ongoing but have thus far been unsuccessful. Most notably, the Secure and Fair Enforcement Banking Act(SAFE Banking Act) was introduced in the House of Representatives by Colorado Rep. Ed Perl mutter. It passed in September 2019, becoming the first stand-alone marijuana bill to be passed by a House floor vote,^[9] but it has been stalled in the Senate's banking committee ever since. The SAFE Banking Act would provide safe harbor protection to financial institutions that work with state licensed marijuana businesses.^[10] Until Congress passes meaningful reform in this area, institutional investment remains largely unavailable to cannabis operators, creating capital shortages and a lack of financial institutions willing to serve as depositories. This often extends to real estate loans where the underlying property is used for cannabis-related activities.

Property owners with existing financing should review their loan documents before leasing to cannabis tenants to ensure that entering into a proposed lease will not cause the loan to go into default. Virtually all commercial loan agreements contain a provision requiring borrowers to comply with all applicable laws. And unless a lease agreement is specifically drafted to be used in connection with a cannabis operation, there is unlikely to be a necessary carve-out from such covenant for federal laws prohibiting the trafficking of cannabis (discussed below). Thus, entering into a lease where the subject property will be operated for a federally illegal purpose requires attention to the landlord's financing documents.

Other challenges relate to the general nature of the cannabis tenant. For example, the tenant's revenue stream is somewhat uncertain; a tenant who loses the required licenses to operate also loses the revenue needed to pay rent. Moreover, cannabis operators do not currently have access to federal bankruptcy protection, which can make it more difficult for them to liquidate assets and pay creditors.^[11] And most marijuana businesses still operate largely on a cash basis, making them an easy target for theft.

There are a few considerations involving federal law that may directly affect landlords. As discussed in more detail below, the Internal Revenue Service might attempt to apply IRC § 280E to landlords with business income and expenses related to the cannabis industry.^[12] And while federal enforcement has largely been limited in recent years to operators who also violate state laws or regulations, there is potential exposure to property owners in the form of civil asset forfeiture in connection with a possible RICO action.^[13]

Navigating the Legal Landscape

In Colorado, the implementation, management, and enforcement of the state's regulatory scheme is relegated to the Colorado Department of Revenue, Marijuana Enforcement Division (MED). The MED oversees the industry at the state level and is responsible for issuing business licenses, vetting potential licensees, and monitoring licensees' activities. But Colorado has a dual-licensing system that requires marijuana businesses to also be approved to operate by the applicable local jurisdiction.^[14]This system also permits local jurisdictions to prohibit the operation of regulated marijuana businesses, and a majority of Colorado local governments currently do so.^[15] The following discussion examines state-level regulatory considerations for landlords.

An Overview of State Regulations

The type of a person's or entity's economic interest in a cannabis-related business determines the level of disclosure required to the MED and the level of scrutiny the MED will apply to vet such person or entity for a state license. Economic interests in a marijuana business generally fall into two categories: (1) equity holders and those who receive a share of the company's revenue, and (2) counter parties to contracts with the business.

Equity holders are further delineated by the business percentage they hold and/or their ability to control the licensed business into two groups—controlling beneficial owners (CBOs) and passive beneficial owners (PBOs). CBOs have a 10% or greater stake in the company and/ or are in a position to control the business.^[16] In certain cases involving qualified institutional investors, the investor will not be considered a CBO until it holds atleast3O% of the company's equity. Conversely, PBOs hold less than 10% of the company's equity and are not in a controlling position.

For purposes of this regulatory analysis, "control" is defined as "the possession, direct or...