How to Navigate Retail Real Estate

Retail trends generally roll in waves, but the waves look more like oscillations in the cannabis industry. Michigan is an excellent example. By 2016, before the state legalized adult use, retailers and speculators were snapping up storefronts at three to five times the going rate. That enthusiasm was unsustainable. Today, you’ll still find dispensaries paying twice as much per square foot as their nearest neighbor, but you’ll also find them paying a lot less.

“The price per square foot was $80. Now it’s down to $8 in some places,” said Richard Goodman, director of information technology at Bricks + Mortar Group, a cannabis-focused real estate broker in Michigan. Despite early optimism and investment, the firm no longer represents properties in Detroit, although some suburbs remain on its list. “The [regulations] are insane. The city is a nightmare to do business with. We are well past the bubble. Anyone who doesn’t understand that is high on their own product.”

Many of the difficulties Goodman sees stem from bad judgment, not just Michigan’s difficult environment. He saw entrepreneurs lease or buy too early, take on too much space, spend too much on elaborate buildouts, and pay for it all with expensive hard-money loans. The market for cultivation property is even worse, he said. “Nothing we’ve seen in real estate has grown like this,” he said. “But nothing has stalled so fast, either.”

With excess inventory in some states, it’s tempting to scoop up a bargain, but experts warn to proceed with caution.

“I almost always tell people not to buy or lease a property that used to be a dispensary,” said Meg Sanders, chief executive officer at Massachusetts’s Canna Provisions. “Those stores are appealing because they are already built out, but there is a reason why those businesses failed.”

One of those reasons is location. Dispensary operators know this as well as traditional businesses do, but they often don’t have many choices. Zoning takes some of the most appealing retail properties off the table for both tenants and owners, especially if they are in the town center or too close to churches or parks. In some jurisdictions, the easiest way to find a legal dispensary is to look for a strip club or get directions to the industrial park just outside the city limits. Maybe that will work, albeit against all retail odds. But if it doesn’t, will that property be difficult to sell or re-lease?

Too many stores

Too much regulation is bad for the industry, but the situation in “Toklahoma” proves the reverse can be equally damaging.

Oklahoma legalized medical cannabis in 2018 and issued low-cost cultivation and retail licenses with unusually few restrictions. Within three years, 7,000 licensed grows and some 1,300 dispensaries sprouted across the sparsely populated state. For perspective, that’s more dispensaries than gas stations. The Sooner State hosts more legal dispensaries than Colorado, Oregon, and Washington combined, according to James Lankford, the Republican U.S. senator from the state, who opposes federal legislation.

Despite initial popular support and a long, lucrative border with Texas, where low-dose medical products are available for a very short list of qualifying conditions, the green explosion was all too much for Oklahoma residents, business owners, and lawmakers. The state imposed a four-year moratorium on all new licenses in August 2022, and the long-planned ballot initiative to add adult use was defeated in March 2023 by a vote of nearly two to one. Owners are having trouble selling property, even at a loss, and renters are on the hook for monthly payments on their shuttered stores.

New York has the opposite problem: Dispensary space is almost impossible to find. A largely unregulated cannabis market resulted in thousands of “smoke shops” located no farther from each other than a pair of Starbucks. All but nine of the shops are unlicensed.

An estimated 1,400 wildcatters occupy hundreds of thousands of square feet of retail space in New York City alone, selling products in every category and price range. These shops, which sprouted in the year-long lacuna between decriminalization and dispensary licensing, do not pay cannabis taxes or carry products grown or manufactured in-state. Low prices and proximity to customers make them formidable competition for the few law-abiding dispensaries. They also occupy properties that could be leased to the first crop of provisional licensees, all social-equity participants. Relatively few suitable spaces are for sale, and most of those are far too expensive for the average buyer.

Retail is essential to all state programs, but New York’s situation is especially dire. Too many cultivation licenses were awarded early in the rollout, and an estimated 300,000 pounds of cannabis and thousands of gallons of oil, collectively valued at about $750 million, are aging in warehouses across the state. Observers and even some lawmakers warn this overstock has the potential to capsize the state’s legalization effort.

Legislation also can jam the pipeline. More than a dozen states require dispensary applicants to have a lease or deed in hand before a license is issued, a rule most cannabis advocates oppose. Some states, such as Michigan and Alaska, require proof of premises before the process even starts. The economics create a steep barrier to entry that hits justice-impacted individuals particularly hard and typically favors deep-pocketed multistate operators (MSOs).

Sumer Thomas, director of regulatory operations for Canna Advisors, is one of many critics. “The problem is circular,” she said. Without a license, “realtors won’t work with you, because it might be years before they get paid. You can’t sign a lease without funding. Investors don’t want to wait either. And in a prime location, there are a lot of competitors, so you can’t wait around. It’s a huge burden and, in my opinion, ridiculous.”

So, how should dispensary owners proceed?

To buy or not to buy?

“What we’ve experienced in the past is that the only way to get into good pockets of real estate is to buy [a property],” said Ryan Brown, former CEO of Oregon-based Groundworks Industries. Fortunately, he said, “investors often have experience in real estate, and it’s really one of the places where it’s easiest to find capital and folks who will partner with you.”

Investors like real estate for a lot of reasons. Obviously, property is an asset that could increase in value and even generate separate streams of income if the building has other tenants. Additionally, canna-phobic lenders in private equity and banking can keep their distance from the industry. Worst-case scenario, if the dispensary fails, they still have a hard asset to sell or re-lease.

And then there’s the leaseback strategy, in which a company sells its property with the intention of staying put. The new owner gets a hard asset already leased to a successful tenant, while the business receives operating capital. Best Buy was a pioneer of the retail leaseback, but the tactic is particularly useful in cannabis.

Innovative Industrial Properties, a real-estate-investment trust (REIT) listed on the New York Stock Exchange, has acquired nearly $3 billion worth of cannabis properties in nineteen states, most of them leased back to original owners including PharmaCann and Ascend Wellness. The San Diego-based REIT owns more than 8.8 million square feet of cultivation, industrial, and retail facilities where tenants almost always pay the property’s operating expenses and taxes. It’s been a great business model, but the softening cannabis market has forced some tenants to default. IIP’s share price has stumbled.

Steven Katkov, an attorney and partner at Cozen O’Connor, has handled real estate transactions in twenty states for MSOs and large single-state operators. Most of them purchase their retail and industrial properties, he said, because that gives them more control over their business and finances. Cultivation requires significant capital improvements in terms of equipment and construction, for example, while retailing depends on a store’s design, buildout, and use.

“Cannabis is a place where you may very well want to control your own destiny and not have a landlord-tenant relationship,” said Katkov. “But that is predicated on the financing, the available capital and lending network, and the ability [of the operator] to raise money.”

Speaking of money, dispensary operators must factor in the tax implications of their property regardless of whether they buy or lease. Under Internal Revenue Code Section 280E, neither mortgage interest nor rent is a tax-deductible expense for cannabis businesses.

Lease is the word

As previously mentioned, most states require retail applicants to have a deed or lease in hand before a license is approved. In newly legal states, competition for suitable and affordable spaces is so vigorous landlords have been known to increase prices before lunch and again after dinner. Nailing down a dispensary space is crucial.

In the most desirable areas, the competition is so fierce it’s vital to act early and, inevitably, often. That’s why so many MSOs and mid-size operations lease even before they win a provisional license. But the risks are high.

Unless they have deep pockets or unusually patient investors, small operators usually rent. For them, leasing means more elastic credit requirements and, after signing and buildout, a consistent monthly cost. Landlords may limit design or use, but they also are obligated to make repairs. Adding explicit permissions and terms to the lease is the most effective way to deflect problems.

However, renters must be prepared to pay more than the laundromat next door. Landlords, like realtors, will charge a “green tax” or premium if they can get it, because they face risks too. Their mortgage holder, insurance company, or other tenants might object to a cannabis business, or another dispensary with plans to open nearby could violate the common 1,000-foot-separation requirement.

Nevertheless, given the uncertain trajectory in mature markets and the economy in general, Jason Piazza, director of real estate for consulting firm WeCann, would “probably lean toward the lease right now” in most places.

He acknowledges creativity can be as important as money. Piazza likes to go off-market to identify green-zoned properties that seem like a good fit for his clients. And if the property is not available? Sometimes that’s better still. One triple-win strategy goes like this: His client dispensary offers the landlord a large, non-refundable deposit to take over the property when the current tenant’s lease expires. However, that tenant may stay in the space on a month-to-month basis until licensing and permits come through. Now, the dispensary has a conditional lease with which to pursue the license, the landlord is not sitting on an empty store, and the existing tenant has time to decide what to do next.

“Everybody wins,” Piazza said. “And yes, we do take more than 6 percent [as our fee], because this is a lot more complex than a regular [real estate] deal.”