The cannabis industry is growing at a rapid pace, creating potentially countless opportunities for entrepreneurs, investors, and large multinational companies. At the same time, the regulatory environment continues to evolve, with 33 states having already legalized the use of marijuana in one form or another.1
As the industry continues to grow, both retailers and real estate companies are raising capital to expand market share with both private and public investment.2 In this article we’ll discuss what investors need to know about cannabis REITs, one of the main ways to invest in an entirely new consumer category.
Overview of the Cannabis Industry
Retail sales of medical and recreational cannabis are projected to exceed $15 billion this year in the U.S. alone, representing an increase of about 40% compared to 2019. Over the next few years, cannabis sales in the United States could be as high as $37 billion.3
Uses of cannabis
Marijuana, cannabis, and hemp products have been used for medicinal and recreational purposes for nearly 4,000 years. There are three different kinds of marijuana that have been legalized entirely or in part by various states:4
- Medical marijuana used to treat various conditions such as epilepsy and cancer-related illnesses
- CBD (cannabidiol) is the non-psychoactive component of marijuana that is often touted as having health benefits including relieving anxiety and depression
- THC (tetrahydrocannabinol) is the psychoactive component of marijuana that frequently generates the most controversy, and can be transformed into items such as tinctures, gummy bears, and other edibles
Ways to invest in the cannabis industry
At a very basic level, investing in the cannabis industry is similar to investing in any other type of commercial real estate:5
- Direct ownership of a property such as a greenhouse or industrial processing facility for cannabis-related products
- REIT (either traded or non-traded) focused on developing, acquiring, and managing property used in the cannabis industry
Investors who opt for direct property ownership may face a higher level of risk compared to other commercial real estate investments. For example, an owner must ensure that the property meets and maintains all of the state’s regulatory guidelines and that the tenant is legally licensed to operate in the facility. Failing to meet requirements such as these could result in the property being closed down and banned from cannabis-related use.
On the other hand, investing in a cannabis REIT may provide a lower level of regulatory risk while providing entry into a rapidly growing segment of the commercial real estate industry.
How Cannabis REITs Work
As with any other type of investment, there are advantages and challenges to investing in a cannabis REIT that investors need to know.6,7,8,9,10
Advantages of a cannabis REIT
Businesses and real estate investors may realize a variety of potential advantages from a cannabis REIT:
- Marijuana companies often find the cost of capital offered by REITs is superior to alternatives on the public or private equity markets
- Utilizing a REIT removes the burden of managing a large portfolio of real estate assets from the cannabis company, allowing the operator to focus on its core competency
- Yields on invested capital are often in the range of 11% to 18%, while annualized dividends sometimes reach 8% or more
- REITs are required to distribute at least 90% of their taxable income to shareholders as dividends
- Ordinary REIT dividends qualify for a 20% deduction under current tax law, with the remainder taxed at the filer’s marginal rate, making REITs an attractive investment vehicle for investors in the highest income tax brackets
Challenges of a cannabis REIT
Earlier in this article we wrote that at a basic level, investing in the cannabis industry is similar to other types of commercial real estate investing. While that’s true, there are also some unique challenges to investing in a cannabis REIT:
- Marijuana is still federally illegal, although the House of Representatives is scheduled to vote on the Marijuana Opportunity Reinvestment and Expungement (MORE) Act before the end of 2020 which would essentially be a first step towards decriminalizing marijuana on a federal level
- Potential and existing tenants of a cannabis REIT must be thoroughly vetted for proper licensing and legality, as business owners who are arrested or forced to shut down would have a negative financial and reputational impact on the REIT
- While many states have legalized marijuana businesses, these same states oftentimes have laws allowing municipalities to prohibit cannabis businesses completely, or zoning that restricts locations near schools or to light manufacturing areas
IRS rules for REITs
A company must meet a long list of qualifications required by the IRS to be approved as a REIT. Some of the most basic criteria are:
- REIT must be a corporation, association, or trust
- REIT cannot be closely held, defined as 50% of its outstanding stock owned by five or fewer individuals
- Proposed REIT must have 100 or more shareholders after its 2nd tax year
- 75% or more of the REIT’s gross income must come from real estate rents, sales, or interest on mortgages
Cannabis Regulation and Legalization in 2020
The regulatory landscape of the cannabis industry is still evolving. In the November 2020 election, citizens in several states will have the opportunity to vote on marijuana legalization through ballot initiatives and state constitutional amendments.11
In addition, the House of Representatives is scheduled to vote on legislation that would remove marijuana from Schedule I of the Controlled Substances Act. The Act currently treats marijuana the same as drugs such as LSD, heroin, and cocaine, and its removal from the list would be the first significant step to decriminalize marijuana at the federal level.
As the cannabis industry develops, governments are creating regulations and policies for how cannabis can be legally consumed and where it can be sold. A recent report from Deloitte recommends conducting normal due diligence before investing in any business in the cannabis industry.12
Important questions for investors to ask include:
- How will government policy affect how cannabis is sold?
- Are there regulations restricting the marketing and promotion of cannabis?
- Which legal professionals should be consulted to ensure regulatory compliance?
- Who are the key stakeholders to consult?
- What are the latest cannabis consumer trends?
- Does the cannabis business have a strong brand presence and deliver a consistent product?
Conclusion
There are many ways to participate in the cannabis industry, including direct property ownership and investing in a cannabis REIT. Although the end zone may continue to shift for some time, investors who engage in the industry early on may be better positioned to take advantage of opportunities in the cannabis industry as they arise.
References
1. https://www.thestreet.com/markets/history-of-marijuana-14718715
2. https://www.globest.com/2019/11/22/cannabis-emerges-a-multibillion-dollar-industry-in-key-states/
4. https://www.thestreet.com/markets/history-of-marijuana-14718715
6. https://vicentesederberg.com/insights/what-is-a-cannabis-reit/
7. https://www.lexology.com/library/detail.aspx?g=5539bf02-7f0c-4fd2-9840-6efe84c264cf
8. https://www.irs.gov/instructions/i1120rei
10. https://www.fool.com/investing/2020/06/21/3-cannabis-stocks-with-the-highest-dividend-yields.aspx
12. https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Finance/gx-fin-cannabis-report.pdf