Phase II Tier 3s - Budgeting for LA’s Cannabis Social Equity Program
L.A. Cannabis Phase 2 Tier 3s - Budgeting for the Social Equity Program
Many Phase II operators are passing their City inspections and about to begin operations. Some may be wondering how they will participate in the Los Angeles Social Equity Program, which many opted to do via the Tier 3 option.
By way of background, the City required Phase II operators to participate in the Social Equity program as a condition of applying for licensing in that round. The majority of Phase II applicants opted for Tier 3 participation, where a business will provide financial support or real estate to a qualifying Tier 1 Social Equity Applicant.
During the Phase II application process last fall, there were not many details provided about the specifics of Tier 3. The City has clarified what form financial support will take and cannabis businesses should ensure their FY 2019 budgets include the City’s Social Equity Program and Property Support Fees, if they decide to go that route.
What will Tier 3 of the Social Equity program look like in practice, and how much should Phase II businesses budget for participation?
Let's hop in and break everything down for you...
Option 1 - Co-locating and sharing 10% of the Business Premises with a Social Equity Applicant - $0 + prorated utilities x 3 years
Many licensees will choose to support a Social Equity Applicant by providing a portion of their current leased or owned space to a Tier 1 Social Equity Applicant to use for their own business.
The terms for this arrangement will be outlined in a Social Equity Agreement which will be processed by the DCR and reviewed by the City’s Cannabis Commission.
If a Phase II Tier 3 licensee chooses this option, they will not need to pay a Property Support Fee, outlined in the next section. The Tier 3 licensee will also need to prorate utilities for the Tier 1 applicant. Note that there are minimum square footage requirements depending on the activity.
The minimum requirements of the property provided to the Tier 1 Social Equity Applicant shall be:
Cultivation – minimum 500 square feet or 10 percent of Tier 3 Social Equity Applicant's Business Premises, whichever is greater;
Manufacturing – minimum 800 square feet or 10 percent of Tier 3 Social Equity Applicant's Business Premises, whichever is greater;
Testing – minimum 1,000 square feet or 10 percent of Tier 3 Social Equity Applicant's Business Premises, whichever is greater;
Distributor – minimum 1,000 square feet or 10 percent of Tier 3 Social Equity Applicant's Business Premises, whichever is greater;
Non-storefront retail – minimum 1,000 square feet or 10 percent of Tier 3 Social Equity Applicant's Business Premises, whichever is greater;
Storefront retail – minimum 1,000 square feet or 10 percent of Tier 3 Social Equity Applicant's Business Premises, whichever is greater;
Microbusiness – minimum 800 square feet or 10 percent of Tier 3 Social Equity Applicant's Business Premises, whichever is greater.
The City seems to favor the co-location option and it addresses the scarcity of correctly zoned property while also sharing resources and support with a Tier 1 Social Equity Applicant. However, many operators do not have additional space to share, or would prefer to pay a Property Support Fee in lieu of co-locating on their business premises.
Option 2 - Paying a Property Support Fee - Est. $100,000 / yr x 3 years
In order to make an informed decision about whether to share 10% of your space with a Tier 1 applicant, or pay a property support fee, it’s important to conduct a cost benefit analysis of each option.
By way of background, the Social Equity Program is designed based on these estimated rental costs for commercial real estate in the City of L.A.:
Estimated First Year Rent for Commercial Cannabis Businesses in Los Angeles
Source: Addendum to the Cannabis Social Equity Analysis Report
Below I will analyze what the estimated Property Support Fee will be for a Phase II Tier 3 operator who is paying $25,000 / month in rent on a 20,000 sq. ft. business premises if they elect to pay a Property Support Fee for a Social Equity Applicant rather than sharing 10% of their space with them.
The L.A. Municipal Code provides three scenarios for paying Property Support Fees:
i) The actual monthly cost per square foot of leased space at the Tier 3 Social Equity Applicant's Business Premises multiplied by the required amount of space pursuant to this subsection multiplied by 36 months;
This option provides subsidized rent for the minimum square footage. The estimated actual costs the City is using are provided in the table above, but these are based on a 2016 source so the actual rents are likely higher.
Using the numbers above, 10% of your 20,000 sq. ft. facility is 2,000 sq. ft.
In this case, you would need to pay (for a downtown property at $2.85 / sq. ft):
$2.85 x 2000 = $5,700 / month x 36 months = $205,200
However, the actual cost for a leased space in the correct zoning for cannabis is likely to be higher than these average costs per sq. ft. the City has published.
Assuming a 1.5x markup for cannabis zoned property, this will look more like:
$4.275 x 2,000 = $8,550 / month x 36 months = $307,800
ii) Option 2 was eliminated because it would be too burdensome on DCR to execute (as of Feb. 2019).
iii) The highest cost per square foot for a) commercial, b) industrial, or c) manufacturing space within the City adjusted annually based on the US Commercial Real Estate Index multiplied by the required amount of space pursuant to this subsection multiplied by 36 months.
This last criteria does not define at which point in time the highest rent is recorded but suffice it to say it will be higher than the previous two, because (i) is based on your rent and (ii) is based on the mean of the rents in your neighborhood, so unless you are paying the highest rent in the City, option (iii) will be the most expensive.
Option 3 estimate, using the cost per sq. ft. in West L.A. (but likely is higher than that):
$7.81 sq. ft. x 2,000 = $15,620 / month x 36 months = $562,320 or more
Option 3 - Provide a Tier 1 Applicant with a separate space in the correct zoning - Est. $100,000+ / yr x 3 years
Option 3 is to provide a Tier 1 Social Equity Applicant with property that is equal to or greater than the 10% of the Tier 3’s business premises and is in the correct zoning for the cannabis activities the Social Equity Applicant is conducting.
The best option for many LA Phase II cannabis operators is likely to co-locate at their space with a Social Equity Applicant who is occupying 10% of the business premises, rather than paying a Property Support Fee or paying for a separate property under Option 3.
Ultimately, it is a business judgment decision and you can use the analysis above to determine whether it is better for your business to co-locate and not pay additional property support fees, or to participate by providing rental support to a Tier 1 Social Equity Applicant outside of your premises.
What’s your social equity strategy? If you would like to set up a consultation to discuss the legal requirements of the program
Lauren Estevez is a Los Angeles based attorney who advises international, multi-state and California cannabis brands, operators, and investors and is nationally recognized as a subject matter expert in Cannabis Law. Her work has been featured on CNBC, Law360 and Cheddar, and she is the founder of LME Law.