Investors in the cannabis industry must carefully evaluate all factors affecting their target market to minimize risk.

The California Gold Rush of the 19th century is an ideal study in risk management. The lure of unimaginable wealth and the romanticism of the American frontier pulled hundreds of thousands of fortune seekers to the soon-to-be state, each with their own schemes to tilt the tables of fate in their favor. Many of these entrepreneurs succeeded in their quests and established themselves as economic cornerstones of the fledgling Golden State. For most, however, the reality was far bleaker, and the results of their headlong rush included rampant criminal activity, degradation of the local ecology, and the devastation of the native population.

These diametric outcomes—feast or famine, elation or devastation—are by no means unique to the California Gold Rush. In fact, they can be observed in the Green Rush of today. As investors and entrepreneurs have surged into the cannabis market to try to capture a portion of the currently estimated $13 billion industry, many have been relegated to the same fate as the less-fortunate gold seekers of the 19th century.

As in any rush into a new industry, proper risk management protocols are often cast aside in an attempt to catch the initial wave of high profits. There are certainly opportunities to tap into the legal cannabis market successfully, and an analysis of overlooked risk factors is the first step toward a successful venture.

What Are the Risks?

The start of the Green Rush can be traced to the 2012 legalization of recreational cannabis consumption in Washington and Colorado. In the intervening decade, recreational consumption has been legalized in 20 more states with an additional 16 states allowing some form of medical usage.

For real estate developers in the U.S., this represents a lucrative but risk-laden opportunity to tap into the multibillion-dollar legal market. Anyone who has performed basic due diligence on the cannabis market knows the largest risk factors are the lack of federal legalization and the inability to access traditional financing options. Although these factors certainly pose a challenge and have given rise to creative funding solutions, investing in the cannabis industry carries additional, more subtle, risks often overlooked by eager investors.

Like those that sought to make their fortunes in the gold rushes of the 1800s, many cannabis investors forgo traditional risk mitigation and due diligence in favor of quick profits. Profitable investment in the cannabis industry requires careful risk management and evaluation of all factors affecting the target market.

Construction Risks. One of the largest risks to a successful cannabis venture, particularly one focused on cultivation, lies in the construction stage. Although this initial construction risk is typical across many industries, it is particularly burdensome for the cannabis industry. There are significant equipment costs, restrictions on development locations, and specialized knowledge required for proper installation of cultivation systems.

Many states have adopted policies that allow cannabis cultivation, processing, and sales but limit the locations where these activities may be performed. For this reason, cannabis sites are often constructed in more remote locations, which may suffer from less efficient supply chains and a smaller pool of contractors to choose from.

Even after investing the capital to procure necessary land, facilities, and equipment, developers can see their cannabis projects come to a halt if the available contractors do not have sufficient experience for the installation of complex lighting and climate control systems.

Design Risks. There are also risks during the design phase of construction. Many investors have only a cursory knowledge of cannabis cultivation and processing and lack the ability to fully evaluate project designs to determine if they meet the necessary specs for desired production. In these instances, engaging a specialized consultant or owners’ representative can help fill potential gaps in the knowledge of the construction team. Regardless, the developer must carefully consider selection of the design-and-build teams to ensure they have the necessary expertise to construct a complex facility for a niche industry.

Market Saturation and Oversupply. Another risk factor that has increased significantly in the last few years is market saturation and oversupply of cannabis products. In many states where cannabis is legalized, particularly in the growing powerhouses on the West Coast, current supply far outstrips demand, leading to growers and distributers sitting on a vast amount of product in storage. This glut has caused legal prices to plummet and has led to the shuttering of many smaller growers who are unable to wait for a return to higher pricing, which may not occur without federal legalization of interstate cannabis commerce.

This is important for investors to keep in mind when deciding where to base an investment as well as which segment of the market they will target. It is also worth considering that the most profitable option may not be investment in a production facility but instead a service provider or auxiliary vendor to the industry. The initial wave of high prices may not return in the established legal states. However, industry growth is still projected as medical demand rises and other states potentially move toward legalization, creating other opportunities for profitable ventures within the industry.

Tenant-Operated Businesses. Many investors decide to gain exposure to the industry by allowing their tenants to operate the cannabis businesses. Although this certainly shifts the bulk of the risk to the tenant, there are still risks the property owner needs to consider.

The primary one stems from the way legalization and licensing are structured in many states. Even in states where recreational cannabis is legal, there are zoning restrictions that limit where cannabis-related business activities can be performed. These location-based restrictions mean that when licenses are issued to the business owner, they are also tied to a specific parcel. As these licenses are legally linked to specific properties, this means the property itself is at risk of having liens placed against it if the tenant’s business falls behind on tax payments.

There have even been instances of property management firms leasing space to cannabis businesses and owners only finding out when they receive notifications from local tax departments informing them their property was at risk of seizure unless back taxes were paid. Because the tax burden on cannabis-based business is often very high compared to similar industries, this represents a significant risk to real estate owners who would otherwise be collecting relatively risk-free income from their tenants.

Profitable Paths Still Exist

John Sutter, the owner of the mill where gold was first discovered in California, was bankrupt a mere four years after the initial discovery. Many of the first cannabis companies of the Green Rush have experienced the same outcome. The initial burst of profits has fallen victim to the dramatic increase in supply and corresponding drop in retail prices, and yet there are still many paths available to profitable investment in the cannabis industry.

The industry is expected to grow significantly over the next decade, and investors that properly manage risk and avoid the “Gold Rush” mentality have the potential to secure favorable returns. As Mark Twain once so eloquently wrote, “History never repeats itself, but the Kaleidoscopic combinations of the pictured present often seem to be constructed out of the broken fragments of antique legends.” Investing is inherently tied to looking toward the future, but the most successful investors will always keep an eye on the lessons of the past.

  • David Jacobs

    David Jacobs is a Senior Project Specialist with Owner Builder Advisors. His experience includes construction labor, construction risk management, and sales. David utilizes his background of both on-site and in-office construction work to better assist OBA clients. David is an avid outdoorsman and spends weekends guiding bike and kayak tours.

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