In the cannabis and hemp industries, capturing the true value of real estate holdings in an M&A deal can be both elusive and central to the overall success of the transaction. Difficult-to-acquire licenses and permits are essential for operating, which often drives up the “ticket price” of property, ignoring operational and market realities that suppress value in the long run. On the flip side, real estate holdings are sometimes considered “throw-ins” during a large M&A deal. These properties can hold risks and exposures, or, in many cases, are under-utilized and present an opportunity to uncover hidden value.

Both Acquirers and Target companies must take specific steps toward understanding the varied layers of risk and opportunity presented by real estate holdings. In the following, we will address some common scenarios and provide guidance on the best way to ensure fair value throughout an M&A deal.

Real estate as a starting point for enterprise value

Leaders of cannabis and hemp enterprises must understand that real estate should be a focus of the M&A process from the very beginning. All too often, c-suite executives are well-acquainted with detailed financial analyses for other parts of the business, but have a limited or out-of-date idea of their enterprise’s square footage, details of lease agreements, or comparable values in shifting real estate markets. Oftentimes it takes a major business event, like an M&A deal, to spur leadership to reexamine and understand real estate holdings and strategy. Regrettably, and all too often, principals come to that realization post-closing and realize they may have left money on the table.

In an M&A deal, the party that takes a proactive approach to real estate considerations gains an upper-hand in negotiations and calculating value. Real estate holdings can provide immediate opportunities for liquidity, cost-reduction, or revenue generation. At the same time, detailed due diligence can reveal redundant properties, costly debt obligations, unbreakable leases, and other red flags that would undermine value post-closing.

For both sides of the M&A transaction, real estate strategy and valuation should be a core consideration of the overall goals and value drivers of the deal. A direct path to this mindset is to place real estate holdings on the same level of importance as other assets that drive value – human capital, technology, intellectual property, etc. Ensuring that real estate strategy aligns with business goals and objectives will save considerable headaches and potential liabilities in the later stages of negotiating and closing the deal.
Qualify and confirm all real estate data

One of the harmful side-effects of a laissez-faire attitude toward real estate in M&A is that the entire deal can be structured around data that is simply inaccurate or incomplete. This inconsistency is not necessarily the result of an overt deception, but too often it is simply an oversight. Valuations can also be based upon pride and ego, without supporting market data.

Let’s visit a very common M&A scenario: The Target company has real estate data on file from when they purchased or leased the property (which may have been years ago), and that data says headquarters is 20,000 sq. ft. of office space. Perhaps they invested heavily into improvements like custom interiors that did nothing to add value to the real estate. The Target includes that number in the valuation process and the Acquirer assumes it is accurate. Following the deal, the Acquirer moves in and, in the worst case, realizes there is actually only 15,000 sq. ft. of useable space. Or it is equally common that the Acquirer learns the space is actually 25,000 sq. ft. Either way, value has been misrepresented or underreported. M&A deals involve a multitude of figures and calculations, and sometimes things are simply missed. But those small things can have a major impact on value and performance in the long run.

The only solution to this problem is to dedicate resources to qualifying and quantifying data related to real estate holdings. When preparing to sell, Target companies should review all assumptions – square footage, usage percentage, useful life, etc. – and conduct field measurements and physical condition assessments (“PCA’s”). This will help your team understand the value of your holdings and set realistic expectations, and perhaps just as importantly, it saves you from the embarrassment of providing inaccurate numbers exposed during Acquirer’s due diligence—and getting re-traded on price and terms. That reputation will ripple through the marketplace.

From the Acquirer’s side, the details of real estate holdings should come under the same level of scrutiny as financials, control environment, etc. Your due diligence team should commission its own field measurements and PCA, and also seek out market comparables to confirm appraisals. It is simply unsafe and unwise to assume the accuracy of any of these details. Performing your own assessments could reveal a solid basis to re-negotiate the M&A, and will help shape post-merger integration planning.

Tax analysis will reveal risks and opportunities

The maze of tax regimes and regulatory requirements cannabis and hemp operators navigate naturally creates opportunities to maximize efficiencies. This is particularly the case when it comes to enterprise restructuring to navigate the tax burden of 280E.

For example, it may be possible to establish a real estate holding company that is a distinct entity from any “plant-touching” operations. By restructuring the real estate holdings and contributing those assets to this new entity it may be possible to take advantage of additional tax benefits not afforded to the group if owned directly by the “plant-touching” entity. This all assumes a fair market rent is charged between the entities.

Recently, operators have looked to sale/leaseback transactions to help with cash flow needs and thus these types of transactions have gained prominence for cannabis and hemp operators. It is important that these transactions be carefully reviewed prior to execution to ensure they can maintain their tax status as a true sale and subsequent lease, instead of being considered a deferred financing transaction. If a Target company has a sale/leaseback deal established but under audit the facts and circumstances do not hold up, this could open up major tax liabilities for the Acquirer.

When entering into an M&A transaction, it is important that the Acquirer look at the historical and future aspects of the Target’s assets, including the real estate, to maximize efficiencies of these potentially separate operations. It is also equally important to review pre-established agreements/transactions to ensure the appropriate tax classification has been made and that the appropriate facts and circumstances that gave rise to the agreements/transactions have been documented and followed to limit any potential negative exposure in the future.

Contract small print could make or break a deal

An area of particular focus during due diligence should be a review, and close read, of the Target company’s existing property leases and other contracts. There are any number of clauses and agreements that seem harmless and inconsequential on the surface, but can have disastrous effects in difficult situations. In many cases the lease/contract of a property is more important than the details of the property itself. For example, if the non-negotiable rent on a retail location is too high (and scheduled to go higher), there may be no way to ever turn a profit.

The financial distress resulting from the COVID-19 pandemic has brought these issues to the forefront in the real estate industry. Rent payment and occupancy issues are shifting the fundamental economics of many property deals and contracts. If, for example, you are acquiring a commercial location that is under-utilized because of market demand or governmental mandate, you must confirm whether sub-leases or assignments are allowed at below the contract price. If not, you could be stuck with a costly, underperforming asset amid quickly shifting commercial real estate demand.

In many leases and contracts there are Tenant Improvement Allowance conditions that require the landlord to fund certain property improvement projects. If utilizing these terms is part of the Acquirer’s plans, you may need to have frank and open conversations with landlords about whether the funds for these projects are still available, and if those contract obligations will be met. Details like these are often penned during times of financial comfort without consequences to the non-performing party, but a landlord struggling with cash flow may not have the capability to meet contract standards.

These are just a few examples from a multitude of potential real estate contract issues that can emerge. It is recommended to not only examine these contracts very closely, but have dedicated real estate industry experts perform independent assessments that account for broader social, economic, and market realities. That independent analysis will help your executive team formulate a real estate strategy that better aligns with core business objectives.

Dig deep to uncover real value

There are countless scenarios where issues related to real estate make or break an otherwise solid M&A transaction, whether before or after closing the deal. The only path forward is to treat real estate holdings with the same care and attention paid to the other asset classes driving the deal. The cannabis and hemp industries have recently endured micro-boom-and-bust cycles that have left many assets under-performing. As Target companies offload these assets, and Acquirers seek out good deals, both parties must undertake focused efforts to establish the fair value of complex real estate assets and obligations.

Catch up on previous articles in this series and see what’s coming next…

As the COVID-19 pandemic moves into 2020’s second quarter, the commercial real estate (CRE) industry is experiencing severe pressure across multiple consumer-related fronts, ranging from hospitality to shopping centers. And, while these direct impacts are having significant effect on the CRE and affiliated industries, the more profound – and enduring – changes likely are still to come.

“Markets that are more likely to be adversely impacted have a relatively high share of leasing activity from the following industries: energy, airlines, transportation, distribution, wholesale trade, hospitality, travel and fitness,” CBRE writes in a recent update report, adding that energy-dependent markets like Houston and Denver will be most affected.

Adds Martin R. Smura, Chief Executive Officer of the Kempinski Group: “This is a very fast-evolving situation with a little outlook on how the situation will evolve in the coming weeks. Flexibility and agility are critical. Crisis, be it economic, social, environmental or health, are to become the ‘new norm’, and we shall adapt our business model and practices to this new paradigm.”

REITs

Publicly traded real estate investment trusts (REITs) took a slightly more severe hit than the broad equities market during the sharp stock market selloff. But their balance sheets remain strong and their debt seemingly manageable. Data centers weathered the storm better than other sub-sectors, while lodging owners and lodging managers were battered with market declines of 40 percent to 60 percent. Mall valuations fell 50 percent and shopping centers declined 45 percent. (More on shopping centers below.)

Shopping centers

The impact on shopping centers, meanwhile, is significant as countless retailers (Macy’s, Gap, Neiman Marcus, Designer Shoe Warehouse and Kohl’s, among the most recent) have announced massive layoffs and furloughs.

Not surprisingly, the International Council of Shopping Centers (ICSC) is requesting states and municipalities to provide help by:

• requiring banks to offer a 90-day forbearance on all commercial loan obligations underpinning the shopping center industry;
• extending the period at the end of 90 days if public safety requirements mandate it, and enable property owners and banks to negotiate appropriate repayment options.

“An increasing number of national retailers and tenants have publicly expressed their intent to skip monthly lease payments during this crisis,” Tom McGee, ICSC president and CEO, writes in a letter to the National Governors Association and U.S. Conference of Mayors. “The non-payment of rent will jeopardize the repayment of up to $1 trillion of secured and unsecured debt held by property owners that underlays the shopping center industry.”

He says the shopping center industry generates approximately $400 billion of state and local taxes that support local communities, public safety resources and infrastructure. Additionally, McGee says most of the $6.7 trillion of consumer spending in the retail, food and beverage, entertainment and consumer service industries occurs within U.S. shopping centers, with nearly one out of four U.S. jobs retail related.

One specific proposed transaction to watch is the $3.6 billion announced acquisition of Taubman Centers Inc. (TCO) by Simon Property Group Inc. (SPG), which is expected to close this year. In late March, however, Taubman sent a letter to its mall tenants informing them they must pay rent during the COVID-19 pandemic.

Real estate deal flow

The deal market is bifurcated at this point, as commercial property specialists are slamming on the brakes when it comes to entering into new deals. New properties aren’t being listed by sellers and buyers are dragging their heels about committing to new purchases.

COVID-19, however, doesn’t seem to be negatively impacting deals that either were underway or near closing.

Regarding valuations, CBRE surveyed its capital markets team in mid-March and heard the following:

• More than half of them have seen sellers delay bringing properties to market
• Some seven in 10 forecast the delays will continue through mid-April
• Of deals that are under contract, 50 percent of the buyers, not surprisingly, are asking for price reductions, with 5 percent the most-popular request.

The company also reviewed “peak-to-trough” behavior for rents and values following the financial crisis and 9/11 and found that (in both cases) rents took some two years to go from peak to trough and then about six years to recover.

Government assistance

In the last week of March, the Federal Housing Finance Agency (FHFA) announced it will grant some leniency to multifamily landlords hurt by the COVID-19 spread.

Owners of multifamily properties subject to Fannie Mae- and Freddie Mac-backed mortgages (which are regulated by the FHFA) will be allowed to forego mortgage payments provided they do not evict renters unable to pay their rent due to the COVID-19 outbreak. The FHFA earlier had said the two mortgage financers – the nation’s largest – would permit owners of single-family residences to suspend mortgage payments for as long as a year without running up late fees.

Handicapping the sub-sectors

Drilling down into the sub-sectors, some of the analysis and conclusions are still preliminary and tentative – largely because of the unknowns. Moreover, the first quarter of the year is typically the weakest for commercial real estate metrics.

Lodging/hospitality: Crash

With some experts predicting a decline in revenue per available room of 60 percent for the second quarter and 37 percent for the full year – compared to relatively flat estimates prior to the outbreak – there is no other way to describe the lodging situation as anything other than an outright crash. Price adjustments, apparently, have had no impact either.

Industrial space: Mixed

This sector is interesting, with the long-term outlook trending toward positive and the short-term sentiments more negative. On the leasing front, near-term activity probably will slow as customers wait for greater clarity on the duration of the pandemic. Logistics-focused space generally is viewed favorably, but there are some concerns about potential supply chain disruptions. Longer-term, increased virtual/e-commerce shopping by home-bound buyers should boost demand for space. Demand for owner-occupied industrial space is also likely to accelerate against this backdrop.

Office space: Jury is still out

A common refrain during this crisis has been lamentations of the end of office life as telecommuting becomes widespread. But history tells a different story. Following the Dotcom boom of 2000-2001, many companies thought they’d save on office costs. The jury came back, with some success stories for certain groups and employees. However, overall, most companies returned to more social campuses and office centers for these reasons: social interaction, productivity and accountability, recruitment and retention.

While we must praise telecommuting capabilities for keeping many businesses open and working, the crisis has also exposed many weaknesses of telecommuting, primarily for those in smaller domiciles, and especially with family at home. There is likely to be a short-term drift to greater telecommuting potential, but the technology has been around for a while, and workers (and businesses) will likely be looking forward to returning to offices after weeks (months?) confined at home.

Occupiers of all asset classes are re-evaluating employee and customer densities in their facilities. We are very engaged in those conversations with users, architects and vendors. The outcome of those exercises will likely be lower density and more emphasis on “drop in” locations, where possible and applicable.

Retail: Balancing in the middle

The verdict: Retail is considered a mixed bag with great weakness where you would expect (enclosed malls, restaurants and gyms), but surprising strength on-line. Dollar stores, consumer electronics, toys and the apparel categories all face potential disruption in the supply chain if the crisis drags on. On the positive side: grocery and pharmaceutical stores.

Multifamily: Delays and shifts

Positive demand is likely to remain in pretty good shape, but it is expected that – at the high end of the market – there may be a transition period due stemming from some delayed moves. Interestingly, the current pressure on senior housing is causing some to forecast a possible shift to single-family rentals and a benefit to that sub-sector.

Seven changes to watch for

Supply Meets Demand: Many proactive real estate companies are taking steps now to expand their footprints as demand is at a near-term low and supply is overflowing. Companies assessing availability, and making moves now, are positioning themselves for long-term advantage when normalcy returns.

Warehouse Space: If ongoing e-commerce continue to take the place of visits to the market, there is an expectation that warehouse space will benefit as retailers’ immediate stock needs will become a different – but very welcome – change.

Stock Market Alternative: Even with the equities market staging some bounce back after the near-30 percent drop in the Dow Jones Industrial Average, some stock investors may conclude it’s time to steer clear of equities. A possible alternative: commercial real estate, which they may conclude is a lower risk in this environment of uncertainty.

Whither High-Density Living? Is COVID-19 the death-knell of collaboration? Roommates in college … roommates after college when funds are scarce … senior living and healthcare facilities – it’s all become a common and accepted part of our culture. But what seemed to be the present and future is now threated by fears about transmitting diseases. Experts already are positing ways to convert flexible workspaces into alternative usage.

Refinancing Opportunities: With interest rates dramatically lower than a year ago, agile commercial real estate investors may choose this time – even with all the uncertainty – to refinance the higher interest rates they currently have on their properties.

Advantage: Tenants: COVID-19 quickly turned the market on its head and what was a solid landlord’s market is now a tenant’s market. Consider: demand for U.S. office space has cratered, just a year after reaching post-2008 highs. Would-be – and adventuresome – tenants may find incredible bargains on office, retail or industrial space.

Spotlight on Self-Storage: This sub-sector is a bit of outlier as it is doing better than its retail peers, even though it is heavily consumer-focused. Attraction: limited human interaction and attractive pricing.

Trusted Advisors: The CRE business, at least for now, is less of a transactional business than it usual. And brokers, as a result, have transformed themselves into advisors, providing their clients with important guidance on how to navigate through this crisis. One topic: landlords and tenants working more closely together.

If you have any questions related to real estate markets, deal flow and other opportunities, please reach out to us for a consultation.

Over the last 10 days, the COVID-19 pandemic has turned the world on its ear. In these uncertain times, we are helping our clients – companies and government institutions that use all types of commercial space across the country – create solutions to keep business moving forward. Conserving our clients’ cash while maintaining honest and fair relationships with the landlords who are essential to long term operations is where we can add additional value in times like these.

Below are some strategic tips to consider when conducting discussions with your landlord regarding your plans moving forward, specifically any changes to near-term rent payments, and long-term plans for the space.

Remind the landlord who you are, and provide specifics:

• Reference your specific lease and date of the lease;
• Mention the length of your time in the space, your close relationship (if applicable), your rent payment performance and any additional benefit your occupancy has delivered to the property or the landlord.

Describe your business situation:

• Quantify your current hardship, and provide specifics: e.g., % drop in sales (for retail tenants), “Shelter in Place” Order, and closure of customer seating, supply chain failures, etc.;
• Provide the new math on this specific rent as a percentage of same-store sales before and after the “Shelter in Place” Order, if applicable in your state. That may help you frame your request in logical terms. Even in a crisis, injecting logic and math into a tense conversation can calm nerves and deliver a positive solution.

Provide the proactive measures you’re taking to get business back on track:

• Describe the active steps you are taking to secure additional funding sources (private and public) to avoid extraordinary layoffs, vendor layoffs, honoring contracts for goods and services, like payment of rent;
• Reinforce the notion of your history as an excellent partner to your landlord in the landlord/tenant partnership. As a small business owner, it wouldn’t hurt here to state how much rent you have faithfully paid this landlord over how many years before you request rent deferral. If you pre-paid rent large sums of rent in the past, remind them now!
• Make a specific request of this landlord in dollars and time and provide the answer to their expected question: “How quickly will I get paid back?”
• Close with a suggestion that you are looking forward to feedback and partnering with the landlord to weather this market disruption.

Ultimately, business is still about personal relationships. Being direct, friendly, and patient while delivering specifics is the best path to a shared understanding with your landlord.

As always, please review your intended action with legal counsel before doing anything that impacts a legally binding contract — and a valuable relationship.

In many cases, MGO Realty Advisors is taking the lead on communications with landlords on behalf of our clients across the country, and across all property types. If you would like support or a consultation, please do not hesitate to reach out.