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A Guide to Safeguarding the Cannabis Landlord-Tenant Relationship

Cassia Rose Furman

A Guide to Safeguarding the Cannabis Landlord-Tenant Relationship
Cappi Thompson via Getty Images

As cannabis legalization proliferates in states across the country, commercial landlords may find themselves weighing the risks and rewards of leasing to a cannabis tenant, turning to counsel to assist with due diligence and lease negotiations. With the COVID-19 pandemic impacting rent rolls moving into 2021, landlord interest in cannabis tenants may even increase, particularly as cannabis businesses have been widely designated as “essential businesses.” In most legal cannabis states, the complex web of local and state government controls, overlaid on federal prohibition, creates an environment of licensing scarcity augmented by limited real property in so-called green zones. Simply put, demand for cannabis licenses, particularly retail and cultivation locations, in most cases exceeds supply. Hastily conceived partnerships and ill-defined agreements are the norm.

In this environment, green zone property owners stand to benefit from renewed interest in underutilized commercial and industrial assets and the opportunity to collect above-market rents from cannabis tenants. Inevitably, however, the reward carries with it attendant higher risk. As witnesses over the years to the frequent unraveling of cannabis landlord-tenant relationships, including lease disputes and defaults, we advise both parties to take an informed, proactive approach to lease negotiations, with an eye to some unique aspects of the cannabis industry. A careful approach to forming the relationship with a cannabis tenant could prevent detrimental financial impacts, including litigation, to befall the landlord down the road.

Threshold Issues

In structuring a cannabis lease, landlords should first consider if their property and financing can support the proposed use, which often must be expressly designated on the lease for the tenant to be eligible for licensure (applicants for cannabis licenses are frequently required to submit the lease to regulators). As a threshold issue, properties backed by commercial financing are not typically eligible for cannabis operations due to loan covenants against activity that violates federal law. Landlords sometimes overlook these provisions and are surprised to find their loan in jeopardy when their next refinancing rolls around. Second, restrictive zoning, including an overlay of “sensitive use” setbacks, and in some cases minimum setbacks from other cannabis facilities, may cause a property marketed as green zone compliant to be ineligible. Brokers and prospective tenants are not always diligent in this area. Landlords should also consider the risk of asset forfeiture by government agencies, a topic beyond the scope of this article but which is an issue to highlight. Finally, commercial properties with cannabis tenants are likely ineligible for bankruptcy protection under current laws.

As a correlative threshold issue, landlords should consider requirements for regulatory disclosure; in some states these extend to landlords. If the landlord participates in profit sharing or incorporates a financing mechanism into the lease, the landlord may be deemed to hold a current or future interest in a cannabis business. This unintended commercial relationship could have more far-reaching impacts to the landlord’s affairs than he or she may realize and requires upfront evaluation.

Tenant Due Diligence

After weighing these threshold matters, the landlord should turn to tenant due diligence. As is true in conventional lease relationships, the best litigation avoidance tactic is often selecting the right tenant. Aligning landlord and tenant expectations before the lease is signed is critical. The nuances of federal prohibition create unique conditions for cannabis landlords and tenants. For example, cannabis operators are often under-insured as there are still relatively few insurers underwriting for the industry, and premiums are high. Cannabis policies typically include many more riders and carve-outs than is standard. In addition to evaluating insurance, landlords should also confirm what tenant or building improvements will be necessary for licensed cannabis operations. Often local governments will require the entire building to be brought up to current code standards, and certain types of uses will require specific and costly upgrades, such as special HVAC and power systems. The tenant’s ability to pay for these improvements should be evaluated, and the lease should specify what happens to certain equipment or fixtures upon termination. As discussed below, both cost and time frame to commence operations are important aspects of the diligence process.

Landlords should also assess the tenant’s cannabis licensure and regulatory compliance position. Often the lease is negotiated before the tenant receives licensure, particularly if the license is location-specific, as is common. Landlords may need the assistance of experienced cannabis counsel to help troubleshoot in this area. Cannabis licensees are held to some of the highest regulatory standards of any industry in the country. Depending on the jurisdiction, operators may be subject to frequent inspections and audits, and face harsh penalties, including license suspension, if they fail to comply with regulatory requirements. These regulatory realities will translate to a distressed tenant and possible default.

Lease Negotiations

With diligence underway, the landlord and tenant can turn to lease negotiations, with an eye to dispute avoidance. Certain conditions unique to the cannabis industry frequently give rise to landlord-tenant issues and should be discussed at the outset.

Disputes frequently evolve from delays in licensure, insidious in the cannabis industry, that result in delays in the tenant fit-out period, occupancy, and opening for operation. Though most often not the fault of the tenant, delays in obtaining local and state approvals to operate can severely impact cash-flow forecasts, resulting in lease defaults and requests for modification. Analyzing and providing for a realistic time frame to open, as well as the potential for litigation around the government’s licensing process, could prevent tenant defaults or other issues.

The landlord should learn what specific cannabis uses the tenant intends to conduct at the facility and draft attendant clauses into the contract. For example, mold damage and odor or nuisance complaints are associated with indoor cultivation and may require specific treatment in the lease. Odor complaints may be an issue for other cannabis uses as well. The parties may wish to describe what “reasonable wear and tear” means for the use, in addition to specifying the responsibilities for mandated tenant improvements, as discussed above. A well-drafted cannabis lease addresses facility access and security, again frequently subject to specific government mandates. Strong security deposit and personal guaranty clauses should be incorporated as an additional dispute-avoidance tactic.

Cannabis Lease Terms

A careful landlord and counsel should carry the theme of litigation avoidance into even the standard lease clauses. In fact, standard clauses are often the most contested provisions in cannabis lease disputes, as tenants or landlords will use them to attempt to invalidate one party’s obligations on grounds of illegality or impossibility. State real estate commission form contracts with multiple addenda, though advantageous for many reasons, can be particularly problematic. Addenda clauses are often inconsistent with the body of the contract or ill-defined with respect to cannabis operations. The following, culled from our experience, are some basic practice pointers for litigation and dispute avoidance:

  • Make sure to carve out standard “violation of federal law” provisions. If they are not present, the tenant could technically be in violation of the lease for the entire term and the landlord potentially in violation of other covenants, complicating a litigation scenario.
  • Include robust and ongoing compliance and licensure covenants. Any lapse in licensure or regulatory action against the tenant must be reported immediately to the landlord.
  • Anticipate a request to assign the lease, as cannabis businesses tend to change hands frequently. Landlords should anticipate emerging market dynamics; five years is an eternity in the cannabis industry.
  • Draft a regulatory changes clause. Contracts may need to be partially reformed, or attendant actions taken, as local, state, and federal cannabis regulations may change multiple times during a lease term.
  • Avoid federal court in a choice of law clause. The amount in controversy in most lease disputes will typically exceed the minimum parameters, but relief in federal courts is not currently available. State court venues may also be difficult depending on the jurisdiction. Arbitration clauses remain favored for this reason.
  • Include an attorney fees provision.
  • The risk of default is deemed so high to some landlords that we sometimes see extremely heavy-handed clauses like confession of judgment or other attempts to enforce contracts outside of the courts. Landlord’s counsel could consider these options but should expect pushback from the tenant.

As the foregoing discussion shows, due diligence and the negotiations surrounding commercial leases for cannabis uses pose extremely idiosyncratic issues, given the complicated and varied regulatory treatment of the industry. However, careful lawyering and sensitivity to these issues can make a significant difference in safeguarding the cannabis landlord-tenant relationship; many issues can be properly accounted for and addressed to avoid downstream conflict and disputes.