Four years ago, California voters passed Proposition 64 and the Adult Use of Marijuana Act. Savvy industry operators, investors and analysts were already forecasting a period of explosive growth, followed by a tumultuous time of aggressive consolidation. Those top-notch brands with staying power, smart business practices and/or incredibly deep pockets were expected to muscle through and be the faces of the industry for the long term.
Today, the early steps toward consolidation can already be witnessed across California and throughout the nation. But what most forecasters didn’t see coming was the major legislative log jams, the never-ending permitting processes, mounting buildout costs, capital constraints and hyper-inflated lease rates that would ultimately cause real estate costs to slowly but surely bleed companies dry as they wait to open. As a commercial real estate broker who advises businesses on making smart decisions when spending money on property, this drives me crazy. The cost of leasing space should never be the main reason a business closes.
How can this be avoided? Here are three important points that are typically overlooked when a cannabis operator is entering into a real estate lease.
1. Understand your target rent-to-revenue ratio
There are a number of metrics that play into the decision to sign a lease. One key metric is the rent-to-revenue ratio. This is the percentage of your annual revenue that goes toward rent expenses, which include base rent AND any common area maintenance or triple net charges. Every industry has a healthy range that it ought to stick to. Whether you are selling hamburgers or vape cartridges, you should spend typically between 3% and 20%, depending on the industry. Remember to do your financial diligence on projected revenues, local tax rates, employee costs, etc. This is needed to determine what your target rate should be at a specific location. Under most circumstances, anything under 15% is considered healthy and is a good benchmark to use.
Remember that leases typically have annual rent increases built in every year, so don’t just look at the first year of the lease when doing this math. Be conservative when calculating your potential revenue. Having goals for how much money you’ll make is essential, but adopting a “low downside risk” planning mantra is best to protect your bottom line.
2. Be pessimistic about licensing time frames
Far too many entrepreneurs have fallen victim to bleeding their bank accounts dry pre-licensing. The city of (Take Your Pick) expects to open applications in August, get through the first four rounds by December and have licenses out by February. Then June comes around and because of lawsuits, accusations of corruption and reevaluations of the process, it feels like there’s no end in sight.
If you aren’t applying in a city with an open licensing program, do everything you can not to get pinned down on an opening date. You’re going to have to pay the landlord something for their time no matter what (it’s only fair), but try to control this amount as much as possible. Unforeseen and uncontrollable delays happen frequently in this industry. You will most likely know more about these challenges than your potential landlord, so walking them through some scenarios and structuring solutions into the lease can prevent major conflicts.
If you can’t negotiate an unlimited “pre-opening” rent period, some solutions to aim for include “kick-out” clauses in your lease, which structure your ability to exit a property in the event of major delays, and paid extensions to pre-opening rental rates in the event of licensing delays (such as adding additional months to the back end of the lease for every month you need to extend). You can also ask that total rent consideration prior to opening not exceed a certain amount. These solutions allow you to cap your financial risk and protect against worst case scenarios.
3. Don’t be afraid to walk away
As exciting as an opportunity may be — and as much as you might believe in yourself and your vision — some deals just shouldn’t happen. Your landlord is a passive partner in your business, and partnerships are built on cooperation toward mutual benefit. If you have a partner who is only looking to protect themselves and get as much as they can out of a deal at your risk and expense, then they are nothing but an anchor.
The search for compliant, leasable space can be long and stressful but don’t be in a hurry to just get into any deal. Keep your money in your pocket and keep looking for the right home.
If you’re on the hunt for your next location, or running into unexpected challenges in your current space, an experienced commercial real estate expert can help you navigate the process. In the long run, it will set the stage for a successful launch or expansion of your company which will pave the way for your success.