ULI Toronto News

The transformative potential of legal cannabis on the Ontario real estate landscape

By: Eunice Wong, EY Transaction Real Estate

It has been more than three months since recreational cannabis was legalized in Canada on October 17, 2018 and the transformation is still unfolding as legal, social, and economic frameworks get implemented. In a dual live broadcast between ULI Toronto and ULI Ottawa at the offices of Borden Ladner Gervais (BLG) on January 24th, 2019, curious real estate professionals and city builders assembled to gain insight on any impacts to real estate that have started to unfold in Ontario as a result of legalization. The panel consisted of professionals with recent direct experience in various stages of the cannabis value chain and specific risks implicating real estate in the context of the key stakeholders: the Canadian public/residents, landlords, licensed producers and retailers, and lenders/investors. While there are differing activities among the various stages along the cannabis value chain, key stakeholders are involved in either some or all stages related to cultivation, processing / extraction, research and development, distribution, and retail / sales.

Moderated by Tamila Ivanov, Senior Associate, BLG, introductions to the panelists’ remarkable experience in the cannabis industry were given. David Wood, Ph.D., Partner at BLG, delivered an eight-minute summary that provided an introductory understanding of the legal and regulatory framework of the Canadian cannabis industry. It was noted that while the regulations were legalized on a federal basis under the Cannabis Act, Health Canada is the governing authority issuing licenses to licensed producers and cultivators and the distribution and retail sale of recreational cannabis is under provincial and municipal jurisdiction. Wood discussed the differences of upstream and downstream activities within the value chain. The upstream activities involve the processing of cannabis, which may involve cultivation, extraction, research and development, and packaging. The introduction of micro-scale licenses will be increasingly popular in urban settings. Downstream activities involve the distribution and sale to adult consumers for the recreational cannabis products. Tracking is required by the Cannabis Act and by provincial legislation. However, each province and territory has the authority to select the distribution and sales model for which to deliver cannabis products. In terms of real estate implications, attention is directed at product understanding as the end products will dictate what real estate and infrastructure needs are required. As the market expands beyond dried flower, other cannabis products will be in the form of extracts (including tinctures and concentrates), topicals, and other consumer edibles. Downstream activities are also heavily regulated in terms of packaging and labelling.

Following Wood’s presentation, Karen Fung, Vice President, Transaction Advisory Services – Restructuring, Ernst & Young LLP, delivered a presentation on the retail landscape focusing on Ontario. The Alcohol and Gaming Commission of Ontario (AGCO) serves as the regulator for private cannabis retail in Ontario and has the authority to license, regulate and enforce the sale of recreational cannabis in privately-run retail stores across Ontario. A total of 25 cannabis retail licenses will be granted in April 2019 through a lottery system, which is intended to be a temporary solution. The application process to operate the privately-owned brick-and-mortar stores will begin in April 2019, with sales to commence shortly thereafter. Consultations with public and private stakeholders will be held by April 1, 2019 as the Ontario government seeks to finalize its private retail framework. Retail stores cannot sell online. The Ontario Cannabis Store (www.ocs.ca) will continue to have government oversight and administration.

THE COMMUNITY
As further normalization occurs simultaneously with changing regulations, property owners (both residential and commercial) are becoming more receptive. With respect to the retail cannabis landscape, Wood suggests that landlords are increasingly responsive to changing regulations in pursuit of adapting of market forces. Retail landlords are now faced with increased tenant and consumer awareness – what kind of target consumer will the property attract and will this change in consumer traffic create a disturbance to the success of the overall retail centre? As municipalities identify and determine how the cannabis regulations will be implemented in their jurisdictions, design standards have not yet been set. This brings in questions on store footprint, branding, and signage; factors that will need to be positively received by the general community.

Travis Grimes, Vice President, Asset Management and Expansion, Canopy Growth Corporation, explained that while the real estate needs for retail locations are highly dependent on location, there are various risks associated with entering the retail market given complexities of municipal constraints. Canopy is a world-leading diversified cannabis and hemp company with operations in 12 countries and five continents. Within Canada, Canopy has 10 production facilities and 11 Tweed and Tokyo Smoke retail stores with approximately 32 more planned by September 2019.

LANDLORDS AND PROPERTY OWNERS
From a landlord’s perspective, Adam Walsh, Vice President, General Counsel, ChoiceREIT, reiterated the rarity of an industry coming onboard overnight. With regards to the retail cannabis framework in Ontario, Walsh noted two major impacts that retail landlords will need to consider:
1. Impact to the shopping centre: How will the tenant mix change? Does the retailer have its licenses in order? What is the regulatory framework in that municipality? What is the distance to the nearest school? Are there other tenants that would be indirectly impacted?
2. Impact to the lease: Are there restrictions on common areas and use of the leased premises? What are the security requirements? Will insurance be void if there is a change in use? What are the waste management implications? What approaches are being undertaken to comply with age of consumption rules? Are there termination rights available in the lease?
While the sale of cannabis products may be permissible at a given property, exclusive use awarded to certain tenants may pose challenging for landlords. In an environment where beer, wine and cider is available in approximately 450 grocery stores across Ontario, it is not unlikely that landlords assess the implication to their anchor tenants and what types of exclusive use is offered per the lease. Other leasing implications for retail landlords relate to Assignment clauses. “Who the tenant is today could be different than who the tenant is who operates it,” Walsh cautions. As a result, the financial strength and operational experience of the retailer is critical to landlords as they assess tenant covenants.

LENDERS AND FINANCING
Fung (EY) reasserted that while major financial institutions and lenders have previously been hesitant to fund LPs, there is a general sense of openness that lenders are approaching with caution. On the retail side, experience in cash management and access to capital are significant considerations to potential financing arrangements. While some retailers lack the financial knowledge, there may be increasingly more cases of non-traditional financing structures. “How do banks make themselves comfortable?” Ivonov (BLG) asked. In such a new industry, banks are essentially turning to tangible assets – the operational facilities, the machinery and equipment, and the underlying land. Fung discussed the limitations of inventory as collateral when seeking financing as the inventories may not be marketable or fit for sale.

In the past year, EY has assisted a number of LPs in the valuation of facilities and equipment for the purposes of debt financing with a major Canadian bank. In their engagements, they have assisted in developing alternative highest and best-use scenarios as lenders continue to gain familiarity with the industry.

LICENSED PRODUCERS
Shifting from the focus on the retail landscape, Grimes (Canopy) discussed the measurable real estate risks that are associated with production facilities. Utilities costs are one of the largest cost drivers in the cannabis industry. While some LPs are seeking to increase automation to decrease reliance on manual labour, the location of production facilities can be critical as utilities costs vary significantly between provinces. Other site servicing needs include water consumption, fibre optics and telecommunications requirements for the performance of advanced technologies and equipment.

When an audience member asked the panelists for their perspective on the cannabis landscape going forward, Jamie Boyce, Vice President, CBRE, mentioned the augmented learning that landlords and municipalities would have to undertake in order to appropriately understand the benefits of the investment. There are a multitude of risks associated with pest infestations, mould, waste, crop failure, and other production-related costs. However, there are also opportunities for landlords and municipalities to invest in innovative and advanced technologies and processes that could be at the forefront of a transformative industry.

Based on the capacity requirements for utilities and infrastructure, facilities that are focused on the processing or extraction will generally be seeking zoning for industrial uses. Grimes affirms that greenhouse facilities for cultivation purposes would likely relate to land zoned for agricultural uses.

Overall, the panel discussion displayed the integration that is required among all stakeholders to implement regulatory frameworks through the enablement of real estate. Licensed producers and retailers are recommended to engage with lenders and landlords as they educate themselves on debt recovery strategies and assess tenant covenants to measure financial and operational risks in a legal framework that is in its infancy stage. It’s inarguable that real estate is important to many aspects of the cannabis value chain and the full impacts are yet to be felt.

Photos by Ethical Image.

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