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Cannabis - The Latest Buzzword on Investment

The legalization of cannabis in many states is creating opportunities for business owners and investors, as well as communities.

Q1 2019
As states move to legalize cannabis for either medical or recreational use, there is an opportunity for socially conscious investors to take advantage of a growing industry and help jump-start what could be a healthy sector for minority-owned businesses. Research shows that by 2025, the U.S. cannabis market is poised to reach $146.4 billion. Looking to states where cannabis is legal, many brick-and-mortar businesses are thriving because the demand for product is high and the supply is restricted. These businesses are able to draw a robust market to their areas.

It is not just urban areas that are poised to benefit. Rural areas are also well suited to gain from investment by cannabis companies. There are significant opportunities for development along any point of the cannabis growth chain, including cultivation, manufacturing, distribution, and retail. Many economically depressed areas in the southeast U.S. are prime areas for cultivating the cannabis plant, including Kentucky, Tennessee, and Oklahoma, and could provide much needed entry-level jobs and job training for these communities.

All points of the cannabis growth chain require specialized facilities that have to comply with special state and local laws, including security, cold storage, zoning, and social equity programs. Rural areas can take advantage of the outdoor farming facilities needed for cultivation, while urban settings will need a grow-house facility to maintain temperature and humidity conditions. Distribution warehouses in any state need to have specialized security and equipment requirements but can be located in urban or rural areas. Manufacturing facilities have similar requirements and are typically located in industrial zones. Retail facilities can be located virtually anywhere depending on laws and always have special requirements for security, location, product separation, and on-site quarantines.

Risks, Pitfalls, and Restrictions
Despite the promise that the cannabis market holds, marijuana remains a federally illegal Schedule I controlled substance. However, during his confirmation hearing, U.S. Attorney General William Barr pledged not to go after marijuana companies that comply with state law. He recently put this pledge in writing, when responding to written questions from senators.

“As discussed in my hearing, I do not intend to go after parties who have complied with the state law in reliance on the Cole Memorandum,” he wrote. The Cole Memorandum refers to Obama-era cannabis enforcement guidance that was rescinded by then-Attorney General Jeff Sessions in 2018. The Rohrabacher-Blumenauer amendment also remains in effect, which prohibits the Justice Department from spending funds to interfere with the implementation of state medical cannabis laws.

Looking to states where cannabis is legal, many brick-and-mortar businesses are thriving because the demand for product is high and the supply is restricted. Another rare risk, but a palpable one, is the potential for a private RICO suit against cannabis businesses. The Racketeer Influenced and Corrupt Organizations Act (RICO) is a federal Nixon-era law originally intended to combat drug cartels and organized crime, and it’s read broadly enough to allow average citizens to bring suit against businesses dealing in a controlled substance. In June 2017, the U.S. Court of Appeals for the 10th Circuit reversed a dismissal of a civil RICO lawsuit by a private plaintiff against a Colorado-licensed cannabis cultivator. Ultimately, a federal jury found in favor of the cannabis cultivator, rejecting the neighbors’ claims that the smells and sounds of the facility damaged their property.

Opportunity Zones Change the Equation
These risks, pitfalls, and restrictive tax laws previously made the cannabis industry tough to break into for investors. Businesses had difficulty raising enough capital to purchase their own real estate and develop specialized facilities. However, the Tax Cuts and Jobs Act of 2017 presented real estate investors and venture capitalists a lucrative gift in the form of Opportunity Zones, which changes the equation for the cannabis industry.

The newly created program provides significant benefits to investors — not only is the capital gains tax deferred on the gains invested in a qualified opportunity fund, partial and full reduction of the capital gains tax may be available to the investor depending on how long the investment is held. The tax benefits are significant, especially for those with large capital gains or investors with long time horizons — i.e., everyone in real estate. With more than 8,700 designated Opportunity Zones across the U.S., the program aims to spur investments in designated, economically depressed areas.

There are significant opportunities for development along any point of the cannabis growth chain, including cultivation, manufacturing, distribution, and retail. According to the Economic Innovation Group, the designated Opportunity Zones have an average poverty rate of 29 percent. The median family income is 40 percent lower than the nation median family income. As the United States recovered from the Great Recession, these areas have been left behind. However, none of that is to say that Opportunity Zones are not a good long-term investment. The tax breaks for investors help to mitigate the risk. Moreover, private groups offer some assistance in guiding investors toward the zones most ripe for investment.

For example, a group consisting of Locus, Smart Growth America, the Center for Real Estate and Urban Analysis at George Washington University, and Strong Prosperous and Resilient Communities for Change has put together a large report grading the various Opportunity Zones “based on its Smart Growth Potential (SGP) as well as its Social Equity + Vulnerability Index score (SEVI).”

Opportunity Zones provide another way to defray costs and risks associated with the cannabis industry and employ unrealized capital gains to invest in marijuana-specific infrastructure. Prior to the Opportunity Zone option, business owners looked to defray costs through antiquated arrangements, such as lease-to-own. Now Opportunity Zones provide a new source of capital and the chance for investors to get in on the ground floor of the fast-growing cannabis industry.

P3s Mitigate Risk
Real estate investors contemplating the cannabis market through Opportunity Zone investments should also consider engaging in public-private partnerships (P3) to encourage risk mitigation. As Brad Alexander, senior advisor with McGuireWoods Consulting, pointed out in a recent article, arranging public-private partnerships in Opportunity Zones helps subsidize the cost of infrastructure and creates greater access to invest in non-commercial zones.

Despite the promise that the cannabis market holds, marijuana remains a federally illegal Schedule I controlled substance. In addition to the risk-mitigating and opportunity-enhancing benefits of P3, the federal government has supported these investments with a directive. On December 12, 2018, President Trump signed an executive order establishing the White House Opportunity and Revitalization Council. The council is tasked “to encourage public and private investment in urban and economically distressed areas, including qualified Opportunity Zones. The council shall lead joint efforts across executive departments and agencies…to engage with state, local, and tribal governments to find ways to better use public funds to revitalize urban and economically distressed communities.”

Opportunities to pair qualified funds with P3 deals at all levels of government are unique investment structures for those interested in real estate and will likely intensify the growth of the cannabis industry. It is one of few industries that can strike the delicate balance of providing a profitable commercial investment opportunity, while bringing much needed capital and attention to underserved communities. With the benefits in play through the Opportunity Zone program, new and current business owners can take on additional risk, more easily navigate the cannabis infrastructure, and tackle the specialized requirements needed with the influx of capital realized through the newly created zones.

For savvy investors and economically depressed communities, the emergence of legalized cannabis — with the aid of Opportunity Zones and public-private partnerships — is a win-win.

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