HEF Finance

Are Cannabis Loan Interest Rates Offensive?

Internally, our team reviews around 3000 lending scenarios a year with cannabis related businesses. A fraction of those scenarios become clients who engage us to obtain bona fide terms. The cannabis industry is unique in its relative maturity still projected to grow dynamically (industry growth projects to increase from $33 billion this year to $84 billion in 2028). While there are emerging brands and established operators, as well as opportunities emerging in more states providing legal framework to produce and sell cannabis products, the dynamic growth of the industry has increased the demand for capital. Funding sources have also expanded in recent years to meet to the demand for borrowers in the space. Adding to the flux, few banks have developed loan offerings in the cannabis industry due to risk factors and the regulatory environment. As such, borrowers have depended largely on a limited number of private money pools to serve growing capital needs which drives up the overall cost of financing. With all of these elements in play in the cannabis lending market, the supply of capital is in flux and the cost of capital is often far higher than in more traditional industries. Our estimations of execution costs, interest rates, appraisal costs, legal fees, and origination points are based on negotiating loan terms on a daily basis for multiple borrowers. Overall cost could be as high as 10 origination points and 15% interest for a real estate and/or construction loan, and as low as 4 points and 9% on a refinance for a performing real estate asset. The high side is very high and the low side is not that low. At times, when receiving feedback on our interpretation of the credit factors and cost, borrowers, often coming from other industries, have used the word “offensive” to describe them. But before shooting the messenger, there are justifiable reasons for higher cost rates and fees in the cannabis space.

The unique difficulty of execution in the cannabis space requires a high level of expertise in specialty financing, cannabis business and real estate valuations, the reconciliation of unbanked revenue, and complex interstate legal issues due to federal prohibition. Moreover, finding real funding sources with a reasonably predictable underwriting time frame and reliable execution of a loan is akin to navigating a financial mine field to find loan execution without games. Firms with a high level of expertise with a track record of underwriting and closing a good number of loans that are best equipped to manage the unique challenges related to the industry are in high demand, and they charge accordingly.

Regular Use vs. Cannabis Valuations

Most hard money lenders base their loan amount on the ratio of the appraised value of a property. In the cannabis lending world, there are lenders who will lend based on an increased cannabis use valuation, and lenders who will only loan based on a regular use valuation. A cannabis lender, working with an expert cannabis MIA certified appraiser, will factor in the higher profitability of a cannabis use property. Depending on the state, cannabis appraisals often come in 20%-50% higher than regular use appraisals. As a result, borrowers working with cannabis lenders and appraisers will typically have substantially greater borrowing power. In the current environment, larger, established markets such as California, Colorado, Oregon, and Washington have a good number of hard money lenders who will lend to cannabis businesses on a lower regular use valuation. Funds that specialize in cannabis use appraisals that fund at higher loan amounts, are far fewer.

Pitfalls

Borrowers seeking debt in the cannabis space commonly encounter pitfalls. Unscrupulous brokers sometimes charge engagement fees in advance and promptly disappear with the money. Inexperienced brokers with good intentions underwrite to real funding sources that require various fees, but deny the vast majority of borrowers who engaged them. Worse yet, they often drag borrowers though 5 months or more of the underwriting process before they decline the borrower.

Supply and Demand

The institutional private debt funds in the cannabis sector that we underwrite to on daily basis have no shortage of capital requests. Turning out a term sheet often requires 3 weeks of underwriting whereas last year, it took 10-14 days. We are seeing, by far, the highest number of loan requests in the first quarter of 2022 than in all prior quarters in the 4.5 years we’ve been underwriting in this sector, and substantially higher average loan sizes. As the industry capital supply has continued to increase, competition to obtain the capital is growing at a faster pace to the extent that a cannabis MIA certified real estate appraiser is typically booked 8 to 12 weeks out (however, larger firms can leverage their volume of business to reduce that appraisal time to 10-20 days). The rising backlog of cannabis underwriting and appraisal requests, along with a sizeable increase in average loan size over the last 18 months, equates to a “seller’s market” as it pertains to debt financing. Essentially, lenders with a track record of execution, are mostly trying to keeping up with demand. As such, in the current environment, they may hesitate to lend at terms at the bottom end of their interest rate ranges that their covenants permit.

Should lenders be offended by your profit margins if you are offended by theirs?

With all due respect to cannabis business borrowers, profit margins in the cannabis space are higher than in many industries. With a range of typically 15%-35% profit in the industry, the profit margins often support a higher cost of debt. In other industries, you can achieve low single digit rates, however, lower profit margins may only cover a low debt cost. Cannabis lenders have seen many of their borrowers make a killing, and with return on the loaned money is often very high. When you ride off into the sunset with your next tranche of capital, give a shout-out, or send a fruit basket, to that lender who executed your loan in a timely manner at a rate that supply and demand have established.

Execution Risk is high

What is the cost of a prolonged underwriting process that takes 5 months or more, or execution failure? You worked hard to get where you are today, and maybe you made mistakes you learned from along the way. Those mistakes can often be the learning lessons that make you the professional you are today. We started working with money pools in this industry 5 years ago and we’ve learned where the land mines are the hard way. We live in the cannabis finance space and we’ve underwritten hundreds of millions of dollars in files. If, in reality, 5% cannabis real estate money was out there, we’d be thrilled to present it to borrowers. However, rumors and claims of these types of money pools do exist, and they draw honest brokers and borrowers looking for what we call internally, “the magic money tree”. In comparison, our candid, real world assessment of the real cost of execution is often seen as offensive. If your goal is execution, consider the opportunity cost of failed execution which is often born out of the assumption that most commercial loan brokers putting their shingle out in this industry have experience in real world execution of cannabis credit facilities. When speaking to a broker or lending source, it’s important to read between the lines. Are they telling you what you want to hear, or do they sound credible and able to ask the questions necessary to try and accurately estimate a predictable outcome? It’s not easy being a firm that presents conservative reality, which we do daily, but it’s that high integrity approach that allows us to build relationships with cannabis business borrowers.