California Cannabis: In 2018, Resolve to Make Your Leases Better

california cannabis marijuana lease
Put your lease on the list!

With the New Year upon us and California cannabis legalization in full swing, now is the time for industry players to make sure they are poised to thrive in the world’s biggest legalized cannabis market. A critical element of that strategy for commercial tenants, as well as landlords, is making sure the real property chosen for operation is properly tailored to the intended use, and is flexible enough to anticipate various adverse scenarios that can and will arise in a dynamic and rapidly changing legal landscape.

A smart and practical New Year’s resolution would be to make sure your lease is buttoned up and ready to go for commercial cannabis in 2018. Here are some points to consider towards that end:

  1. Stop using form leases. Yes, they’re easy and convenient, and checking boxes is certainly cheaper in the short term than writing a lease, but experience says one of two things will likely happen: either you will (1) end up spending just as much time writing addenda that cancel out, expand upon, or replace terms of the form lease, making it read more like a choose-your-own-adventure book that flips across chapters, or (2) you won’t, but you’ll be far more likely to run into costly problems down the road when you discover the lease is missing crucial pieces that would have helped you avoid a mess. Save yourself the trouble and plan ahead by working with an experienced real estate attorney who understands the proposed use and the industry in California, and can write a proper lease to fit the tenancy.
  2. Specifically describe the permitted use and define applicable law. There are important legal consequences under state and federal law for adult use cannabis operations vs. medical operations, and the state’s regulations require specific authorization from the landlord for whatever license the tenant will obtain. And of course, there remains the issue of federal illegality overhanging everything. To save everyone time and headaches down the road, make sure the parties are in clear agreement on exactly what categories of licensed activity will be allowed under the tenancy, specify that in the lease, and restrict it to that use. Simply writing “cannabis” or the evasive “any use not in violation of law” will not suffice. When it comes to applicable law, local law and state regulations should be front and center, and there should be a carve-out for inconsistent federal law, lest a tenant be in violation of the lease from day one.
  3. Keep it arm’s-length, or know the risks. Entanglement issues such as profit-sharing arrangements and equity-as-rent may be lucrative, but they require a higher risk tolerance. If a federal (or state) enforcement action occurs, the chances that the landlord will be considered part of the offending business may be higher than if the lease had been a traditional arm’s-length tenancy. Also, you might run into problems trying to enforce the lease if it amounts to asking the court to wade into cannabis business operations as opposed to enforcing an arm’s-length rent relationship.
  4. Clarify insurance obligations and anticipate increased operating expenses. Regardless of whether the landlord or the tenancy will be responsible for maintaining and paying for building and property insurance, the parties should realize that: (1) cannabis tenants will have a hard time finding quality property insurance policies right now, and (2) any new or existing policy will likely be much more expensive when a cannabis use is added to the property. In practice, this means that the parties need to decide who will be required to obtain and maintain which kinds of coverages, what the policy limits will be, what happens if that doesn’t happen, and who will bear the increased cost if it does. If it’s a multi-tenant building where common operating expenses will increase disproportionately due to the new tenant’s cannabis use, the lease should account for that and adjust accordingly.
  5. Do due diligence on the property first. Doing things like zoning and title analysis would more typically be associated with a new purchase than a lease. But with cannabis uses there are unique considerations that come into play, such as easements or CC&Rs that prohibit violation of “any laws”, water use rights (which will be a critical part of a state application, particularly for cultivators), and zoning restrictions. On that last item, it’s imperative that the proposed site not run afoul of local restrictions, and it behooves both the landlord and the tenant to have that issue ironed out before pen touches paper. The parties should consider including a due diligence period in the letter of intent, as well as including an early termination option for a variety of land use restrictions that could be triggered by cannabis use, including changes in zoning laws.
  6. Consider the neighbors. We’ve discussed at length how RICO lawsuits have found their way into cannabis land use disputes, as well as nuisance claims, and how NIMBYism will likely play a role in the California cannabis saga just as it has in other states. But similar to a zoning and title analysis, parties looking to start a commercial cannabis tenancy can and should factor the neighbors into the equation before deciding to commit to a lease. This is particularly relevant for business parks or multi-tenant buildings with non-cannabis tenants that might complain about the effect of cannabis (odors or otherwise) on their business operations. Better to know now than 3 years into a 10-year lease term. The parties can also consider including an early termination option in the event that neighbors bring a civil action.
  7. Consider the federal government. One of the most obvious reasons that form leases are wrong for cannabis tenancies is the failure to properly account for the fact that cannabis is still federally illegal, and the government can and does pursue civil asset forfeiture, putting the landlord at risk of losing the property over the tenant’s use. While there is no getting around the fact of federal illegality, one strategy is including early termination options for changes in federal law and/or enforcement guidelines, and for any forfeiture actions.
  8. Anticipate the license timeline. California has just started issuing temporary licenses to applicants who already have local approval. While those have had a relatively quick turnaround, full annual license application review could take longer, and in any event, there is the possibility that the tenant will be denied a state license and/or local approval. This uncertainty can be built into the lease in terms of rent abatement and an early termination option, depending how confident the parties are that approval will be successful.
  9. Make sure the occupancy plan stays legal. California’s new regulations dispensed with SB 94’s requirement that a licensee maintain “separate and distinct” premises for multiple licensed activities. However, licensed premises must still have a designated area dedicated to only one licensed activity at a time, with the exception of adult-use and medicinal operations being allowed to operate in the same place under certain circumstances. The new rules also contain a blanket prohibition on subletting of any licensed premises. This means that the parties should spell out in the lease exactly which activities will be conducted in which areas of the property. Whereas typical commercial tenants would have more or less free reign to use the leased premises however they choose as long as it’s within the permitted use, California’s new rules make this a more nuanced issue.
  10. Choose the right law, venue, and dispute resolution process. Limiting interpretation and enforcement of the lease to California law, restricting venue to state courts, and including a well-drafted arbitration clause are all important aspects of a cannabis tenancy that are typically missing from a form lease.

As we watch California’s regulatory and licensing process play out, landlords and tenants with properly tailored leases and well-researched land use analyses will be more likely to succeed and thrive. Many of the potential problems with the leasehold interest will have been considered and averted.

In 2018, resolve to make your leases better.