A flurry of merger and acquisition activity in the U.S. cannabis sector is fueling the need for expansion capital, and some real estate investment trusts are stepping in to fill the financing gap.
The small cohort of REITs that have opted to specialize in cannabis-related properties say the sector has outperformed most other types of real estate over the last few years, with rates of return averaging in the double-digits — significantly higher than non-cannabis industrial real estate assets.
"The yields that we are receiving, certainly relative to traditional real estate asset classes, are tremendous. That's the benefit of powering through all [the] challenges and difficulties," Power REIT President and CEO David Lesser said.
The three equity REITs specializing in the U.S. cannabis sector are Power REIT, Innovative Industrial Properties Inc. and NewLake Capital Partners Inc.
Buoyant sector
The U.S. cannabis sector is thriving, a reflection of soaring product sales and the rising number of states approving legal cannabis programs. Legal cannabis sales reached $25 billion in 2021, an increase of about 40% from 2020, according to market research firm BDSA.
Growing momentum in the sector has also recently spurred hundreds of M&A deals. As of Feb. 28, 259 cannabis-related M&A deals have taken place in the U.S. in the last 12 months, according to S&P Global Market Intelligence data.
Expansion requires capital, which is where REITs come in. Operators sell their property in exchange for cash and can remain in the property by signing long-term leases.
"If they still have real estate that they own, they'll come to us for sale-leaseback [deals] to raise that capital. So that's one way we're seeing benefits from M&A," Innovative Industrial Properties President and CEO Paul Smithers said.
The growth of the cannabis sector in the next three years alone is going to generate tremendous demand for real estate, according to Smithers. He noted that when states move to adopt a recreational program, both revenue and demand will triple.
"I think we're going to see a lot more states coming on with the November [midterm] election. So we're thinking next year, with new opportunities, it's going to be really an exciting year for us," Smithers said.
Filling the capital gap
Many financial institutions are reluctant to deal with the myriad of anti-money laundering laws, regulatory hurdles and potential penalties that stem from working with cannabis-related companies.
"Across the board, there is a challenge for a lot of these public operators to access capital. And if they're private, it's very similar as well. It is still a smaller pool of institutional capital that's willing to invest in direct plant-touching cannabis businesses," BTIG LLC analyst Thomas Catherwood said.
Obtaining capital through one of the few traditional lenders in the sector can be significantly more expensive and may involve selling off part of the company. In contrast, REITs offer a source of nondiluted capital, meaning that operators can access money without being forced to sell shares.
There are also a number of active mortgage REITs in the sector, including Freehold Properties, AFC Gamma Inc. and Chicago Atlantic Real Estate Finance Inc. Mortgage REITs specialize in originating mortgage loans and mortgage-backed securities, earning revenue from the interest.
Cannabis operators are often relieved to find an alternative to giving away shares of the company, as that is what many had to do when they first started, according to Smithers.
"When we provided an alternative to that, they were very happy to see us," Smithers said.
Innovative Industrial Properties is the largest REIT in the sector by number of properties. The company generated total annual revenue of $204.6 million in 2021, up by 75% from 2020, according to executives on a Feb. 24 earnings call. The firm also invested $714 million in new acquisitions, the highest amount of any year since it was founded.
Essential is good for business
The cannabis sector quickly attracted interest at the onset of the pandemic, as every state with a legalized medical or recreational cannabis program classified it as an essential industry.
"That was the first eye opening event for major investors that had been on the sidelines,” Catherwood said. “And if that was the beginning, then 2021 was definitely a continuation of that momentum."
Legalizations are also rising. In 2021, state legislatures in Connecticut, New York, Virginia and New Mexico passed legislation approving cannabis for recreational use, while Alabama passed legislation approving a medical program.
NewLake Capital Partners anticipates the industry will need an additional 10 million square feet in the next couple of years, President and CIO Anthony Coniglio said. Significant expansion is expected in the northeast, where New Jersey, New York and Connecticut will be rolling out recreational programs over the next 18 to 24 months.
Because the cannabis industry is so regulated and specialized, it may continue to deter some institutional lenders from getting into the sector in the future, Coniglio said.
"It's a level of complexity that isn't consistent with where banks would want to play. And in fact, you don't see a ton of bank capital supporting certain real estate sub-segments, like data centers or lab space. Again, it's serviced primarily by those groups that have that specialized knowledge," Coniglio said.
Targeting limited license states
Certain states with legal cannabis programs have a very limited number of available licenses for cultivation, testing, processing and distribution. Those states are where most cannabis REITs are focused on buying property, according to Catherwood. Examples of limited license states include New York, New Jersey, Nevada, Massachusetts, Illinois and Florida.
Innovative Industrial Properties started off focusing on limited license states because those marketplaces are more controlled, with better pricing stability, Smithers said. However, as the industry has matured, the firm has expanded into states with more licenses and dual programs.
NewLake Capital Partners is also focused on limited license states, though high-quality properties in mature markets like Washington and Colorado are still of interest, Coniglio said.
"We will invest in an unlimited license location. It's just, in those instances, we will be more discerning about the property itself and the financial metrics around that property, versus a limited license state," Coniglio said.
Momentum is building
The sector shows no sign of slowing down. BDSA has predicted that U.S. cannabis sales will reach $30 billion in 2022 alone, while the Marijuana Business Factbook estimates that annual sales could reach as much as $45.9 billion by the end of 2025.
Further legalization of medical cannabis is already underway in 2022. Missouri passed a legal medical cannabis program on Feb. 2, and the industry is watching both North Carolina and South Carolina, which are due to vote on the issue this year.
For recreational use, Delaware, Rhode Island and Maryland are expected to debate the issue in 2022. New Mexico legalized recreational use in June 2021, and sales are slated to start by April 1 of this year.
Federal legalization would be the most likely catalyst for accelerated growth in the cannabis industry in the future, but is unlikely to happen any time soon, Catherwood added. Despite that, he expects the industry to have another record-breaking year in 2022.
"I expect 2022 to be better than 2021. And the reason for that is really driven by expanded state medical programs, and by additional state legalizations of recreational use," Catherwood said.