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The Real Deal Los Angeles

Joint ventures

As California’s recreational marijuana laws take effect, many are preparing for the sector to explode, but operators will grapple with the challenge of finding affordable real estate in which to operate
By Justin Sayles | January 19, 2018 09:00AM

(Illustration by Dushan Milic)

When Derek Peterson’s company Terra Tech closed on two new Southern California properties recently, it likely paid up to 25 percent more than another business would have — but Peterson still thinks they scored a deal.

It’s a markup that’s largely expected in Peterson’s industry, legal marijuana, a market segment that got another dose of legitimacy after California’s recreational use laws went into effect this January. In the end, those high costs could pay dividends for a firm like Terra Tech, a cannabis company that already has storefront medical marijuana dispensaries and cultivation facilities in place.

Peterson, a former Wall Street executive who dove into the cannabis business more than five years ago, said that Terra Tech last year purchased the two buildings in Santa Ana — a 30,000-square-foot warehouse and a separate 40,000-square-foot structure — for about $17.5 million combined. It worked out to about $250 per square foot, a relative bargain once you factor in the scarcity of industrial spaces in the area, regulatory requirements that restrict where such operations can be located and the hodgepodge of other issues marijuana businesses face.

“I think we got a decent deal, but we paid a premium over what we would have if we were a widget manufacturer,” Peterson said in an interview in December.

Peterson isn’t alone in his willingness to pay more to get in on California’s growing Green Rush. But while most experts say the industry’s exponential growth is all but certain, cannabis-related businesses face a slew obstacles, including high costs on both the retail and industrial sides, unwelcoming cities and landlords and a new threat from the nation’s chief law enforcement official.

The Green Rush

California voters legalized medical marijuana in 1996 with the Compassionate Use Act. It marked the first ballot initiative of its kind passed by any state in the country, though 28 others and the District of Columbia have adopted medical marijuana laws since.

The medicinal marijuana system, which requires users to get an ID card and a doctor’s recommendation to purchase pot, has meant big business for the state. Dispensaries in California sold more than $2 billion in medical marijuana in 2016, according to a report prepared for the California Bureau of Marijuana Control by the University of California Agricultural Issues Center. Los Angeles alone lists more than 150 licensed medical marijuana businesses on a city-maintained online database.

But that medical marijuana figure was dwarfed by the estimated $5.7 billion in nontaxable sales that took place in the state illegally, the report said.

In November 2016, voters took a step that could bring some of the black-market activity out of the darkness and into the light by approving Proposition 64. The ballot initiative, which followed the lead of states such as Colorado and Washington, legalized adult recreational use and the facilities that cater to it, both of which are still illegal on the federal level — a distinction reiterated by U.S. Attorney General Jeff Sessions in January.

The new rules could be a huge economic boon for the state, which is positioned to become the largest legal weed marketplace in the world, according to a report by cannabis-industry monitoring firm New Frontier Data. The new rules could spark a compounded annual growth rate of over 23 percent with sales reaching an estimated $6.5 billion by 2020, which would rival California’s $7 billion wine industry, the firm found.

It’s clear that investors see the possibilities.

“Everybody is running to be involved in cannabis right now,” said David Feuerstein, a New York–based attorney with Feuerstein Kulick who works with marijuana-related businesses throughout the country. “What they’re seeing is that there are outsize potential returns for investment … I always make the comparison to the internet in the mid-’90s.”

But don’t expect dispensaries to pop up on every corner of L.A. County. Prop 64 created a framework that allows cities and counties to control recreational dispensaries and cultivation and extraction facilities via permitting or an outright ban in their jurisdiction.

The city of Los Angeles, thanks to voter approval in March 2017, will permit recreational use, though the framework is still being developed. Businesses were allowed to apply for licenses starting on Jan. 3, but if approved, they still need a separate license from the Bureau of Cannabis Control. (The city’s existing medical marijuana dispensaries would be given precedence over new applicants.)

For the moment, though, most cities in the area have gone in the opposite direction from L.A., according to data provided by Harris Bricken, a law firm that has worked closely with cannabis-related businesses in California. The vast majority of the 88 municipalities in Los Angeles County have ordinances banning dispensaries and cultivation facilities — even for medical uses — at least for the time being.

Notable exceptions include West Hollywood, which allows retail, delivery and on-site consumption permits; Long Beach, which allows medical facilities but may consider recreational-use facilities  this year; and the small community of Lynwood, which permits cultivation, manufacturing, distribution and delivery but not retail stores. Compton and Culver City are among the areas set to consider ordinances this year.

Hilary Bricken, who heads Harris Bricken’s L.A. office, said that the approach most cities in Southern California are taking is not surprising, given the industry’s newness and the sometimes conservative nature of the region.

“With the politics that are present, [cities] have not been afraid to ban in order to wait and watch, or they’ve been entrenched in saying, ‘We don’t ever want this as an economy,’” she said.

Retail’s pot markup

Those conservative attitudes toward legalizing marijuana laws have created an environment where suitable properties are scarce and commercial landlords and sellers know they can demand top dollar from cannabis clients.

Most cities that allow the industry to operate dole out licenses in a lottery-like system, and all restrict how close a cannabis business can be to schools, churches and other sensitive zones.

(Click to enlarge)

“Whatever the normal prices are, we’ll see it go up two or three dollars a square foot,” said Justin Galindo, a commercial real estate agent who heads 420 Property Finder, a division of cannabis-industry consulting group 420 College. “Just because it’s zoned, the landlords are marking up the prices.”

Galindo, who works throughout California, said that he’s scouted retail marijuana locations throughout Downtown L.A., particularly the vacant storefronts on Broadway and Main Street. But despite the opportunity to fill those sometimes distressed properties at a hefty markup, he said not all landlords are ready to welcome marijuana businesses and often cite the risks of the industry, odor and other potential nuisances when he speaks with them. It’s a “stigma” he likens to the Prohibition era.

“So, the cities are telling us, ‘Here are all the zones and it’s allowed in this area,’” he said. “We call the landlord, and if it’s leasing, they’re like, ‘Nope, I don’t work with that type of business.’”

Those factors, combined with California’s two-decade-old medical marijuana industry, could mean muted effects in the local retail market, said Christopher Muoio, a senior quantitative strategist at online real estate marketplace Ten-X. The medical system allowed “everyone who wanted a card [to] get one,” he said. Muoio anticipates that most existing dispensaries will add recreational sales, something enabled by L.A.’s fledgling recreational marijuana regulatory framework.

Muoio noted that there’s been a large uptick in retail absorption in states that have legalized marijuana, “especially in areas with younger demographics and a little more dense population,” but said that’s been greatest in areas that didn’t have any existing medical pot program.

“Denver and Seattle kind of went from zero to 60,” Muoio said. “California already had a lot of this in place. It was just under the guise of medical.”

Hans Mumper, executive managing director of Colliers International’s Greater Los Angeles region, agreed that the hype hasn’t yet translated into new storefront openings.

Despite landlords’ ability to charge higher rents — potentially as much as two or three times higher than they could fetch from a traditional user, he said — they assume the risk that comes along with housing a business that is federally illegal and that may have difficulty accessing financing.

“Institutional owners probably don’t want to deal with that,” Mumper said. “It will probably be more local ownerships and private individuals that are willing to take that risk for that upside.”

All of this puts the operators of marijuana businesses in a difficult position. While Peterson said Terra Tech was fortunate to land its two recent Santa Ana properties — which are located in high-volume commercial areas — that’s not always the case. He said his company looks for “vertically integrated properties” that can house roughly 3,000 square feet of retail, 10,000 square feet for extraction and roughly 15,000 to 20,000 square feet for cultivation. And which, ideally,  comes in an inviting facility that includes parking.

But this wish list often amounts to searching for a “unicorn,” he said. “You see so much of this business get pushed off to industrial and light industrial areas,” he said. “But you look at more developed markets like Colorado, and people will have traditional retail facilities [selling marijuana] right next to a Subway, for example.”

Despite the difficulties, some commercial brokerages are working on drawing pot businesses to the heart of L.A. Recently released marketing materials from Cushman & Wakefield for a commercial building in Downtown Los Angeles highlight its location in a “marijuana cultivation & manufacturing zone.”

Cushman’s Mike Condon Jr. and Kelli Snyder billed their 55,580-square-foot commercial property at 1114 South Los Angeles Street as a “versatile commercial property.” Representatives for Cushman declined to comment on the listing.

Industrial, as well as some commercial, properties in District 14 — which includes DTLA, Boyle Heights, Northeast L.A. and surrounding areas — are among those zoned for the cannabis business.

Mumper said that despite the push from brokers, the hesitancy of landlords   means that any spillover effect into the retail sector may take a while to materialize. However, some spots, like certain restaurants, may benefit from a location near a dispensary.

“It’s going to have to evolve — who are those customers, and which customers are you trying to attract for these other businesses that may benefit from people showing up to the dispensary?” Mumper said.

Industrial case in po(in)t

A great case study on legal marijuana’s effects on the industrial market can be found 1,000 miles to the northeast of Los Angeles.

A CBRE report on the Colorado capital markets found that in the second quarter of last year, Denver’s marijuana industrial footprint represented roughly 4.2 million square feet, or 2.9 percent, of the market’s total warehouse inventory. Those properties — generally distressed or underutilized Class B or C buildings — saw a sharp spike in prices when the state legalized recreational use in 2014. The 2014 average sales price of marijuana-occupied industrial properties in Denver was $98 per square foot. By the second quarter of last year, it was $115 per square foot, more than a 17 percent increase, the report found.

Marijuana-occupied properties in the Denver area can still expect to pay  25 percent more than other industrial tenants for Class B and C warehouses, the CBRE report found.

Spencer Levy, CBRE head of research in the Americas, said in an interview that he found some spillover effects on the Denver-area industrial market as a whole, but “not as much as you might expect,” particularly because of the city’s 2016 decision to cap the number of marijuana-related licenses it issues.

“There was a very positive short-term impact on a small piece of the [industrial] market, but the broader implications were relatively small,” Levy said

Levy cautioned against drawing too many conclusions from the Denver study about the impact recreational use would have in the Southern California market, but the remarkably low industrial vacancy rates in L.A. could compound the issue. (CBRE’s fourth-quarter 2017 industrial market report showed a vacancy rate of 1.2 percent in the Greater L.A. market.)

“If you’re going to bring a new user into this market, like this industry, you’re taking an extraordinarily tight market and you’re putting more demand on it,” Levy said. “It certainly could lead to an even greater demand from a capital markets perspective and an occupier perspective.”

However, Ten-X’s Muoio expects the recreational marijuana industry to have limited effects on L.A.’s industrial market, explaining that the city is dominated by distribution facilities and trade in the Port of L.A., and cannabis isn’t likely to supplant those uses.

“I find it hard to imagine that even if cannabis really scales up that it will even be able to compete with those uses,” Muoio said.

Sessions sends it up in smoke?

Shortly after Jan. 1, in a period that should have seen the cannabis industry in California begin to take shape, a memo from U.S. Attorney General Jeff Sessions added a level of uncertainty for businesses operating in the sphere.

In it, Sessions rescinded an  Obama-era policy, authored in 2013 by then-Deputy Attorney General James Cole, which  essentially said that while pot remained illegal on the federal level, it was not an enforcement priority except as it related to violent crimes and distribution to minors. Sessions, a longtime critic of marijuana and its effects, said in a statement this month that his memo “directs all U.S. Attorneys to use previously established prosecutorial principles that provide them all the necessary tools to disrupt criminal organizations, [and] tackle the growing drug crisis.”

While the memo doesn’t directly change laws or set enforcement priorities, Feuerstein, the New York attorney, said in an email that “[a] very complex and complicated area of the law just got more complicated.” He added that Congress could respond by extending an amendment, currently set to expire in late January, that prohibits the Justice Department from spending funds to interfere with the implementation of state medical cannabis laws. Additionally, it could expand that amendment to cover adult recreational use.

Bricken, the L.A.-based attorney, said this month that she’s advising her clients it’s “business as usual” for now, but that they “have to get familiar” with their local U.S. attorney’s office. California has four U.S. attorney districts, and each one will have different priorities. Some may choose to continue with the enforcement policies of the past four-plus years, while others may use federal law to crack down on businesses.

Reading the leaves

While the legal recreational side of the industry has yet to take root in Southern California, most cannabis professionals said that already some portions of the business could be overvalued and ripe for consolidation.

Bricken went so far as to call it a “bubble … that will burst because a lot of these people are going to bail.”

“We’re going to see a lot of abandoned assets,” she said. “As a result, I think there’s going to be a lot of leverage for outsiders to come in and negotiate lower rents and lower prices to purchase these businesses.”

It could also be a boon to cities outside of major population centers, said 420 Property Finder’s Galindo. Like liquor licenses, permits for marijuana businesses are tied to properties, so if a company can’t find space in L.A., for example, it can’t apply.

But companies could look to more remote locations that might be willing to roll out the green carpet, Galindo said. He’s found locations like California City and Coalinga — small desert communities that don’t have robust tax bases — more amenable to the industry than some cities.

Cannabis businesses operating in those jurisdictions have helped plug budget shortfalls, put blighted properties like former prisons back into use and had a secondary effect on residential markets. (A September 2017 report by Leafly, which reviews medical marijuana strains, found that legal cannabis supported 149,304 jobs in the U.S. in 2016, with California accounting for more than 47,000 of those.)

“A city can be completely against it, but if they change their mind, it can change an entire city,” Galindo said.

Peterson said that he expects chains will form as more merger and acquisition activity takes place, particularly as the industry settles in the coming months and years. There’s a lot of businesses that won’t be able to survive in “the huge paradigm shift” of operating in a highly regulated market, he said.

But that regulated market is going to benefit the marijuana industry in the long run, Bricken sad. She hopes it will bring cannabis businesses more into the mainstream, and that strong but fair regulations in cities such as L.A. and Long Beach will cut down on NIMBY-style complaints and allow the industry to attract good businesspeople.

“Ten years ago, [a marijuana-business operator may have] been some gray-market/black-market guy who would’ve had some felony convictions in his history trying to start a business that was fly-by-night,” Bricken said. “That is decreasing rapidly.”

And as the recreational industry gains legitimacy, it could mean major profits for companies that know what they’re doing, Peterson said. That makes the gamble of the high real estate costs, stringent permitting process and the whim of U.S. attorneys worth it for Terra Tech.

“Most of us that are in it aren’t in it for the return today,” he said. “We’re in it for the return five, six or seven years from now when the business normalizes.”