By Josh Rabinowitz and Jack Ucciferri

With dozens of jurisdictions in California having recently approved initiatives to tax and/or regulate cannabis, a wave of commercial real estate owners up and down the state are already in, or about to enter into, negotiations with would-be marijuana-related business (MRB) tenants. Those landlords will be acutely aware that such opportunities exist amid a commercial real estate market downturn, as the COVID-19 pandemic has expedited and amplified changes in demand for traditional agricultural, retail and office space.

A significant share of those landlords will walk away from potential MRBs after an assessment of the risks. Some of the landlords who decide to move forward—even some who have inked MRB leases in the past—will incur more risk than they may understand by venturing into the MRB.

As with any commercial lease, prospective landlords to MRBs can dramatically improve the risk profile of a prospective tenancy by thinking through each element of the anticipated relationship and incorporating prudent language into the lease.

Here are a few thoughts regarding some easily missed pitfalls—and corresponding adaptations—for commercial real estate owners considering leasing to an MRB.

Know thy would-be tenant:

Before you make any commitments, you will want to be confident that the prospective tenant is likely to perform their end of the bargain. As with any industry still transitioning from illegal to regulated, California’s cannabis space is still populated by many cannabis operators who haven’t fully transitioned out of the unregulated “traditional” market. Others have a reputation for cutting corners, betraying partners or not paying their bills.

In addition to traditional financial due diligence of a prospective tenant, conducting thorough background, legal and reputational due diligence on a would-be MRB tenant is perhaps the single most valuable step that a landlord can take in mitigating their risk. Landlords should be patient and wait for the right MRB tenant.

Include escape (termination) clauses:

Landlords will want to maintain a right to terminate leases to MRB tenants early and without penalties in specified situations. In such a highly regulated industry populated by new operators, it is not uncommon for a tenant to breach state or local cannabis laws. Alternatively, tenants might find themselves unexpectedly unable to secure requisite local licensing. Carefully drafted escape clauses can provide landlords some protection in the event, by way of example, a tenant fails to achieve licensing, maintain adequate compliance or otherwise jeopardizes a landlord’s interests.

Traditional lenders are still averse to cannabis in a portfolio:

Traditional lenders generally require “compliance with all laws” as part of their boilerplate lending agreements. Unless and until the federal government passes the necessary policy reforms, cannabis’ federal illegality will continue to jeopardize existing financing relationships for many landlords of MRBs. Being held in breach of such clauses has the potential to be extremely costly to a commercial landlord.

Unfortunately, leasing to an MRB on one parcel jeopardizes financing arrangements for other parcels within a portfolio. Some landlords attempt to mitigate this risk by inserting early termination language into the lease or by refinancing the property with a lender who understands and accepts the risks of state-legal cannabis.

Anticipate the cannabis cash problem:

Prospective landlords should stipulate the manner and means in which rent will be made before consummating a lease. MRBs are likely to prefer paying in cash. Most banks are still averse to banking cannabis cash, but a growing number of institutions welcome the funds. Check with your bank on their cannabis policy.

Disclosure to licensing authorities:

Many cannabis lease negotiations contemplate landlord participation in the revenues of the prospective tenant, or percentage rent. An important consideration is whether such an arrangement might trigger disclosure of the landlord’s interest as an “owner” or “financial interest holder” of the tenant MRB.

Local and state licensing agencies require such disclosures based on certain thresholds. Governments primarily require disclosure of MRB interest holders in order to ensure that MRBs are not owned or financed by criminals, but there is a risk that being publicly linked to an MRB could negatively impact a landlord’s relationships with insurers, lenders, partners or government entities.

California’s regulated cannabis industry is growing and filled with opportunities for commercial property owners, but it can also be extremely risky if the issues are not properly considered and then mitigated through a carefully negotiated and drafted lease. The above list is far from exhaustive and each potential transaction is unique. It is important to evaluate and draft each cannabis lease with an experienced attorney who understands the nuances of the cannabis laws in the subject jurisdiction.

• Josh Rabinowitz is a shareholder at Brownstein Hyatt Farber Schreck in Santa Barbara. Jack Ucciferri is a law clerk with Brownstein and member of the firm’s Cannabis & Industrial Hemp industry group.