Green Leaf Brief Blog

Podcast: Securing Retail Space for Your Cannabis Business (Episode 2 of 2)

July 19, 2024

Read Time: 15 mins

 This is the second episode in More with McGlinchey’s two-part series on the ins and outs of retail space in the cannabis industry; click here to listen to part one.

Obtaining retail space for any small business is a big move. There are many issues to consider, and working with a knowledgeable real estate lawyer helps to avoid surprises down the road. This episode discusses licenses for retail space for cannabis businesses from the landlord and tenant perspective. Hosts also review issues unique to the cannabis business when renting retail space. 

Douglas Charnas: Welcome to our second podcast in our two podcast series on retail space for your cannabis business.

I’m Douglas Charnas, a member of McGlinchey’s Washington, DC office. I practice corporate and tax law. I’m joined today by my colleagues, Perry Salzhauer and David Waxman.

Perry is located in McGlinchey’s Seattle, Washington office. He represents clients on a broad range of corporate and environmental matters. His years of working on business processes, SEC, and environmental compliance make Perry uniquely qualified in the emerging cannabis space, where navigating complex compliance and regulatory implementation is a major barrier to entry and ultimate success. David is located in McGlinchey’s Cleveland, Ohio office. He represents clients on matters pertaining to real estate acquisition, development, redevelopment, construction contracts and transactions, environmental compliance and insurance finance, opportunity zone transactions, leasing and business acquisitions, and divestitures.

In our first podcast, we discussed the difference between using a license or a lease for retail cannabis space. At the end of that podcast, I was left with additional questions.

David, assuming I could enter into a license for the retail space, is there a reason why I would want to do this? Or are there reasons why the landlord, tenant, or both would not want to use a license?

The owners of small businesses are many times required to personally guarantee the lease for the retail space. And if the business fails, the owner of that business is going to be on the hook for lease payments. In some states, a landlord has no duty to mitigate or lessen damages. So what does that mean? A landlord doesn’t have to find a new tenant for the remainder of the lease, so you’re on the hook for the whole thing, regardless of whether the landlord sits on its hands.

David Waxman: Well, Doug, as you know, most small business ventures are risky, and the cannabis business is probably more risky than most, given the headwinds created by cannabis remaining illegal at the federal level. It’s important to also remember that a cannabis business can’t avail itself of the federal bankruptcy laws. So, debts can’t be discharged in bankruptcy like they can in a non-cannabis business. The owners of small businesses are many times required to personally guarantee the lease for the retail space. And if the business fails, the owner of that business is going to be on the hook for lease payments. In some states, a landlord has no duty to mitigate or lessen damages. So what does that mean? A landlord doesn’t have to find a new tenant for the remainder of the lease, so you’re on the hook for the whole thing, regardless of whether the landlord sits on its hands.

So, the tenant may be obligated to make the lease payments for the remainder of the lease term, even though the business has gone under. Because of the landlord’s right to terminate the license at will, the licensee may be able to limit its liability under the license if the business fails. Another consideration is the length of the commitment the cannabis business wants to make to the retail space. If it wants a short-term arrangement, a landlord may be more amenable to a license than a lease. Every business, especially a small business, plans on success. But it’s important to also have an exit strategy. And having said this, there are reasons why a license is just not a good idea for a retail cannabis business. You know, honestly, regardless of which side I’m on, as a general rule, I’d never go with a license over a lease. First of all, it’s not common to do that for spaces that are going to be there for a while.

There are also a number of reasons in addition to that. However, three are, in my opinion, determinative. First, the very nature of a license itself. Again, the licensor’s ability to revoke the agreement at will, the retention of absolute control for the premises, and the licensor having to supply the licensee with all essential services required for the licensee’s permitted use of the premises. For example, utilities, trash removal, et cetera, things that you’re normally going to have in a lease that are going to be a tenant’s responsibility. So, none of those factors really benefit either party in dealing with it in terms of a license. Second, for a number of reasons, in the cannabis area, the nature of a license is just not conducive to a cannabis license arrangement. For example, it’s essential that a cannabis operator have exclusive control of the space. As we’ll discuss later in this podcast, state cannabis laws aren’t going to permit somebody without authority under a cannabis license, regardless of whether it’s a licensor or a landlord, to have exclusive control over a cannabis licensee’s space.

And a cannabis operator is also going to be very hard-pressed to agree to provide a property owner the right to terminate its possession at will. There’s just too much investment, and termination of a right to occupy the space is likely, as Perry stated before, to result in the termination of the operator’s cannabis license. In other words, too much risk. As Perry also explained earlier, some states aren’t even going to accept the license as proof of control of a space; rather, they’re going to require proof of a leasehold interest. Space agreements for cannabis operators, as you can see, are not simple endeavors because they’re commercial transactions that are relatively complicated in the first place. And to add to that level of complexity is the complexity that we have because of federal illegality and state cannabis laws. Once you go through that and look at it, you’re going to quickly realize the simple license agreement is just not going to suffice.

A detailed lease agreement is honestly the only practical and rational transactional format. The reason why a lease is the way to go is leases are more complex agreements. They deal with many more issues than a license agreement is going to deal with. They’re going to need to address complex factors such as defense waivers, choice of law, where a lawsuit can be brought, or more importantly, in the cannabis area, where it’s prohibited from being brought, security equipment and procedures, work letters, in other words, for construction of improvements to the space, the ability to assign the agreement, and other critical provisions in this. Perry, I’m sure, is going to discuss many other complex issues that are going to need to be addressed in a space agreement. Finally, as I explained, the lease license factors aren’t absolute. Once you start messing with them, though, things start to become less and less clear, requiring that you have to be extremely vigilant in drafting these agreements. Now, mistakes, whether intentional or not, increase the more one form begins to merge with the other. As a result, the risk to the parties increases. So, in my opinion, as a transactional lawyer, I want to draft with precision, and I don’t want to leave any room for doubt wherever possible. If you want a space license, draft a space license. If you want a lease, draft a lease, and do it the right way.

A detailed lease agreement is honestly the only practical and rational transactional format. The reason why a lease is the way to go is leases are more complex agreements. They deal with many more issues than a license agreement is going to deal with.

Perry Salzhauer: Well, Dave, it might not be in the retail context, but there actually is a scenario where a license might be the best way to move forward. Something I’ve advised clients for a very long time, even if you have a license in one jurisdiction, the most cost-effective way to enter another jurisdiction is to license your trademark or your IP to a state-level licensee in the other state. And we see this a lot with unlicensed “brands” in the cannabis space, right? A lot of people look at the cannabis industry and they see, well, this company doesn’t have a license, but I see their products in the stores. Now, generally speaking, there are three ways if you are not licensed in a particular jurisdiction for you to get your products onto shelves. One is a traditional white label agreement where you basically just license your trademark to a state license processor.

They produce their own products; they slap your label on it and ship it to stores. The second way is a contract manufacturing agreement where, let’s say you have your own formulations that you developed in your home state, and you want to sell them out there in another state where you’re not licensed. So, in that case, you would find a state-licensed processor in the state you want to be in, and you would license both your trade secrets/formulations and your trademark. And, at the state level, the state license processor would manufacture them for you. Now, the third method, which is a lot more complex, and we’ve seen this a lot, particularly in the early stages of opening of a state program, right? Let’s say you have your own expertise and you have your own personnel, and you have your own trade secrets, you have your own trademarks, but what you don’t have is a state-level license or space. What you can do, and we see this, is effectively embedding your own production facility within a state-licensed processor. And I think a license would be really advantageous for that because most, if not all state-level marijuana regulations, have a provision that prevents a licensee from subleasing any portion of their property or otherwise not having complete unfettered access to all portions of a licensed premises. And when I say licensed, I mean state-licensed premises. And it might get a little confusing here over the next few minutes when I use the word licensed in several contexts. So let’s say you are an edible manufacturer and you have a brand, and you’ve been successful in one state, but you don’t necessarily want to spend all the money that it would take to get your own space and your own license in a new jurisdiction.

You find a processor, a distillate manufacturer, or someone who makes the raw ingredients that you need for your products, and they have a state-level license, but they don’t have any edible manufacturing experience, nor do they have the appetite for it, pardon the pun. So what you might want to do is embed yourself into their facility by licensing some of their space, building your own kitchen production facility with your own people. This effectively allows you to control your own production and eliminates the fear that I always hear from clients when they’re in a contract manufacturing setting, which is, well, is my manufacturer going to steal my formulation? The answer is hopefully not, but you never know, and enforcement’s on you. So you can avoid that problem by licensing a portion of their premises and running your own operation without having to worry about whether or not they’re going to mess up your formulations or mess up your production.

And the reason why I think this works, Dave, is because the licensor in a real estate license always maintains full access to the property. So you have a scenario where you are in compliance as the state-level licensee, you remain in compliance with the prohibition against subleasing and the requirement of maintaining unfettered access, but you’ve also allowed someone else, some other operation to utilize a portion of your space to run their own operation. And, in some ways, you can generate some revenue, you can defray some of your 280E charges potentially because it’s not your space, and kind of solve this problem. The other remaining regulatory issues are you need to make sure, as the state-level licensee, the processor licensee, that all of the employees of your real estate licensee are authorized to be in the premises because, ultimately, it is your premises.

Another example of when a real estate license might be advantageous in the cannabis space is if you have a joint venture. Let’s say you are a cultivator and you’re engaged in a joint venture with another cultivator to generate clones, and you form a new subsidiary and you want to track everything separately because the JV allocations are different from the parent allocations, you might then enter into a real estate license between the top-level, state-level licensee and this joint venture. And that way, you can substantiate your cost allocations when it comes to real estate charges when you’re putting together the books and records for the JV. So I guess all that is to say, I wouldn’t say that a license is completely, you know, out of context, so to speak, in the cannabis industry.

So you can avoid that problem by licensing a portion of their premises and running your own operation without having to worry about whether or not they’re going to mess up your formulations or mess up your production.

David Waxman: Perry, that’s such a great point to make because as you said, this happens in the cannabis industry with brand licensing. And that brings into account, obviously the regulatory issues that you spoke about, and it also brings into account the relationship between the landlord and the tenant as the licensee and the licensor that’s coming in with its product. So while you, of course, number one is to comply with state regulatory requirements, but don’t forget that if you anticipate doing something like this, you need to discuss this with your landlord while you’re negotiating your lease and discuss how this is going to happen. Because in a commercial lease, you’re going to have assignment and sublease provisions that, at times, will limit or sometimes completely prohibit any assignment or sublease. This, of course, is intended not to be a sublease or an assignment, but a traditional license. So you need to discuss this with the landlord and have specific language in your lease in that provision, accepting out this situation so that there is no argument going forward when you begin operations where a landlord says, Hey, you either couldn’t do this, or you needed my consent to do this, and we’re going to tell you to get that operation out of your space.

Douglas Charnas: Well, Perry, are there issues unique to the cannabis business when renting retail space? For example, one of the landlords I spoke with was not sure it could rent to a cannabis business. It said it needs to review its loan documents to determine if renting to a cannabis business would violate the loan documents. Another landlord said it might have issues with its insurance carrier if it leases to a cannabis business.

Perry Salzhauer: Yes, absolutely. And I’ve been on both sides of all of these issues in the decade-plus I’ve been working in the cannabis space. But before I dive into that, I just want to support what Dave said, which is certainty. Certainty is just about the most important thing you could ask for in a transactional context. And leaving things up to chance doesn’t benefit either the landlord or the tenant in any context, particularly in cannabis. So, starting with what you mentioned. Most commercial loan documents will have a provision that says something like the mortgagor or the trustee may not allow any activity on the premises that violates the law. It’s usually broad, and it usually covers federal law. As we discussed earlier, state-level marijuana businesses remain illegal on the federal level. So that’s a violation of your mortgage, and it could result in the acceleration of the loan.

…these are broadly drafted provisions in your standard insurance binder. So, it is likely going to include violations of the Controlled Substances Act. So again, your insurance might not cover you if you’re a landlord and something happens, particularly I’ve seen this happen, because of something a cannabis tenant did. How does a landlord protect themselves from this? It all comes down to the drafting. You need to include provisions that the landlord can terminate the lease without any penalty, without any risk of being countersued if some of its documents are violated.

With all of the other default provisions that might come into play, and I’ve seen this play out both from the landlord and tenant side, it is never a good situation to be in. Another common clause we see in a lease that’s impacted by the cannabis aspect of a tenant is insurance provisions. Insurance provisions in the landlord’s insurance policy might similarly prohibit any illegal activities. Again, these are broadly drafted provisions in your standard insurance binder. So, it is likely going to include violations of the Controlled Substances Act. So again, your insurance might not cover you if you’re a landlord and something happens, particularly I’ve seen this happen, because of something a cannabis tenant did. How does a landlord protect themselves from this? It all comes down to the drafting. You need to include provisions that the landlord can terminate the lease without any penalty, without any risk of being countersued if some of its documents are violated.

Now, that’s not good for the licensee tenant’s perspective because it’s not necessarily their problem. So, a lot of this goes to the certainty aspect; it needs to be discussed in the negotiation phase when you’re talking to a landlord. I see cannabis leases, and Dave and I have worked on some, that are just inappropriate for a cannabis tenant. And you read these leases, and you say, well, that’s probably a default, that’s probably a default under that document, that’s a default under that document. And you’re scratching your head, and you’re like, these things need to be negotiated and custom-tailored. Now, even the more subtle aspects, like what tenant improvements must the landlord consent to your general lease, are going to say that all tenant improvements or modifications are subject to the landlord’s consent. Generally, it’s not going to be unreasonably withheld.

Okay, that’s all great, but what if there are material changes that need to be made to the building in order to comply with things like odor requirements? Right? Fencing, signage, and things like that need to be discussed on the front end so that the landlord can’t then all of a sudden deny the tenant the right to do these things. Now, from the landlord’s perspective, you definitely don’t want a tenant willy-nilly making changes to your building. So again, it just highlights the importance of discussing these things at the beginning. And then, of course, the lease needs to be specific about the permitted use. We can get really deep into the weeds here, making distinctions between state-level regulated marijuana and cannabis that’s described as hemp, and a hemp processor and what cannabinoids are allowed here and what cannabinoids are not allowed there. I think that’s probably the subject for a different podcast, but it just goes to being very specific about what the permitted use is because the legal landscape here is sometimes murky, and you want to want to make sure that both parties understand what their rights are.

…in the cannabis area, you want to stay as far away from percentage rent if you’re a landlord as possible…You start getting into being an owner or something akin to that, which requires you to go through a process similar or identical to what a licensee for that business is going through. So there’s no reason in a cannabis situation for a landlord to come anywhere near percentage rent.

David Waxman: I can’t agree with you more on that in terms of being very specific and accurate about what you’re doing. It really behooves both parties to have serious discussions about expectations and requirements before drafting so everybody is on the same page. When you get into this stuff, one of the issues I’ve seen come up relates to rent. It’s not uncommon in retail space to have a percentage rent requirement, which is a percentage of the tenant’s gross income or profits, depending on how it’s defined. In some cases, basing some portion of the rent on profits may be advantageous to the tenant because it can lower the amount of its fixed rent. You’re going to have fixed rent. That’s the standard sum you pay every month. And then, depending on how much you make, you have percentage rates. So, it’s a really intense analysis when a landlord and tenant are determining how to do this.

But in the cannabis area, you want to stay as far away from percentage rent if you’re a landlord as possible. Because then you get into, as Perry said, we can start getting into the weeds; it’s probably another podcast. You start getting into being an owner or something akin to that, which requires you to go through a process similar or identical to what a licensee for that business is going through. So there’s no reason in a cannabis situation for a landlord to come anywhere near percentage rent. For that reason, any lease that I’m drafting for a landlord is going to stay as far away from the percentage rent conversation as possible. Another thing that a landlord would want to include in a lease is that it’s not going to take possession of the tenant’s inventory when the tenant defaults. That’s a problem because in any state where cannabis is legal, there is no way a landlord’s going to be able to take possession of that, and they’re not going to want to take possession of that for so many reasons. So what you’re going to have to do in your lease is you’re going to have to have some other type of arrangement that needs to be made for the inventory. Without a cannabis license, a landlord’s not going to be able to sell that inventory to recover accrued or future rent anyway. And you have issues with even going into receivership, whether a receiver has the right to do that, you don’t want to get into that morass.

Probably the most important escape clause for a tenant is one that would allow the tenant to terminate the lease or delay commencement of the lease if it doesn’t get a license. Now, this obviously applies only to tenants who are first applying for their licenses. This will protect the tenant, but it also motivates the landlord to do what it can to ensure the tenant gets the cannabis license.

Perry Salzhauer: Yes, what David mentioned is exactly correct, and it takes cannabis retail leasing so far outside of the comfort zone of what traditional retail landlords are used to, right? They’re used to percentage rent, they’re used to being able to take all the inventory, but like David said, you can’t do that. You need to have an exit strategy, right? Probably the most important escape clause for a tenant is one that would allow the tenant to terminate the lease or delay commencement of the lease if it doesn’t get a license. Now, this obviously applies only to tenants who are first applying for their licenses. This will protect the tenant, but it also motivates the landlord to do what it can to ensure the tenant gets the cannabis license. Now, other standard escape clauses that we put in are things like if there’s a threat of government authority for criminal or civil penalties, if the tenant’s at risk for an investigation or prosecution by the federal or state government, or if state or local laws change, making the business illegal or financially impractical.

And finally, one of the biggest escape clauses we need to have in there is if the tenant violates applicable cannabis laws or loses its license, the landlord needs to be able to terminate immediately, right? Because the landlord could then find itself in a situation where it has an unlicensed tenant engaging in flagrant violations of the Controlled Substances Act. That’s not a good situation as a mortgagor, or it’s not a good situation just in general. So the final thing we always put in, and while it’s unlikely to happen, in my opinion, there should always be an automatic termination to protect both parties if the federal government seizes the premises and decides one day that it’s going to start enforcing the Controlled Substances Act against state-licensed and legal cannabis operators.

one of the biggest escape clauses we need to have in there is if the tenant violates applicable cannabis laws or loses its license, the landlord needs to be able to terminate immediately, right? Because the landlord could then find itself in a situation where it has an unlicensed tenant engaging in flagrant violations of the Controlled Substances Act.

David Waxman: A landlord is going to insist on a provision that is probably going to be, unless you’re really paying attention as a tenant in negotiating a lease, is one that’s going to require the tenant to indemnify the landlord for any damages that are incurred as a result of any federal or state enforcement action in connection with the cannabis business. And this is important because, really, the only way a landlord is going to be able to secure payment if a default happens is to have the individual or individuals that own that cannabis business guarantee the lease. So it’s not going to stop there. They’re going after you personally. So you better have somebody who knows what they’re doing working with you, and be very careful when you’re negotiating these leases.

Douglas Charnas: Well, Perry and David, thanks so much for this helpful information. This concludes our second podcast in our two-podcast series on renting retail space for a cannabis business.

I wanted to thank our listeners for joining us today. The cannabis team at McGlinchey is ready to assist you with obtaining retail space for a cannabis business or any other cannabis-related issues that you may have.

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