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A major player in cannabis commercial real estate lending, Newport Beach, California-based Pelorus Capital Group was founded in 2010 by high school buddies turned business partners Dan Leimel and Rob Sechrist, who today serve as CEO and President of the company, respectively. Originally formed to provide specialized financing alternatives to value-add real estate, Pelorus entered the specialty finance cannabis real estate lending market in 2016 following the success of the friends’ local congressman in getting a historic piece of cannabis legislation passed into law.
“Dana Rohrabacher is responsible for the most consequential cannabis legislation to ever pass to this date, which at the time was the Rohrabacher-Blumenauer Amendment; it’s now the Rohrabacher-Farr Amendment,” explained Sechrist during a recent call with Cannabis Business Executive. “It defunded the Department of Justice from any prosecution of a cannabis-related business in a medically licensed state. So, that passed in 2014, and Dan said, ‘Rob, let’s go in this direction.’ He’s generally the one that originates and underwrites, and I generally am the one that raises the money, and I’m like, ‘It’s going to be impossible to raise the money. Let’s hedge our bets and do a fund for cannabis and a fund for non-cannabis.’
“But you never want to launch two investments concurrently, and you have to pick a lane, so I decided that if we’re going to go for it, let’s do cannabis,” he added. “And it was enormously challenging to raise capital in that sector. We could raise millions of dollars in less than 30 minutes, and we had raised hundreds and hundreds of millions, but when we went to cannabis, we were only able to raise about $1.5 million the first year. That is not sustainable. Dan and I planned to bring lots of money into the company, and even by the second year, $6.5 million is not even close to being sustainable. But we stuck it out and by the third year, we were up to $56 million, and then $240 million, and then $345 million, and currently we’re at $380 million.”
I asked a question using the term investor to describe Pelorus and was promptly but gently corrected. “We are a lender,” said Sechrist. “When you use the word investment, that means you own the property, and you get profit or loss. We are not looking for a profit and loss. We’re just looking to get yield from the coupon of those notes. We’ve been private money lenders our whole careers, and so we already had the skill-set to do these types of loans. It’s just that nobody had figured out the nuance of doing it for cannabis. So, we are not investing in cannabis, and we’re not picking winners and losers of cannabis-related real estate and trying to buy and flip that or monetize that. We’re simply underwriting that transaction and lending on it.”
Pelorus offers a model described by Managing Partner Travis Goad in an article published last year as being “as close as you can be to pure real estate lending in this sector while also being properly collateralized. What sets us apart from our recently launched lending peers is that we lend against the real estate asset value only, even though we’re collateralized by the real estate and license.
“We lend between 60% and 75% of the value of the real estate, which means sponsors need to raise equity for the 25 to 40% remainder of the project cost,” continued Goad. “This allows us to be covenant light for our borrowers, while giving them the flexibility to grow their business as they see fit.”
I asked Sechrist about that 25 to 40 percent remainder. “That’s the borrower’s equity, and in most cannabis transactions that equity is going to initially come from cash, and they have to raise that cash by selling parts of their company, raising it from their friends and family, or whatever they might be doing,” he said. “Let’s say that there is a cannabis-use piece of real estate that’s going to be bought for $5 million, and that there’s going to be $5 million of improvements to that property for a total cost basis of $10 million. In that particular scenario, if we’re lending for that property build-out, we would lend up to 60 percent of that total cost basis of $10 million, so we’re going to lend up to $6 million, and the borrowers would have to go raise $4 million in cash. When we go to close that transaction for them, and let’s say they’re acquiring the property and they’re going to build it out, they need to put $4 million cash into escrow, and we’re going to put up $6 million cash to finish off that transaction.”
What happens if the lender has to borrow that other money with onerous terms that might impact their ability to pay Pelorus back? “There are two sides to that,” said Sechrist. “One is how we establish the cost basis, which is by every single dollar that we can verify has been put into that property or will be put into that property. Going back to our example, if the property purchase price is 5 million, there’s going to be a purchase contract, and $5 million is going to go through escrow and to the seller, so we’ll be able to verify that through the closing statement. But the other $5 million of tenant improvements that is going to be the building of the property – the repositioning, the A/C power, whatever might be in that $5 million budget – if it hasn’t been completed yet, then it’s going to be verified by us because we’re the ones that underwrote that budget, and we’re the ones that reviewed that budget, and we’re the ones that are going to disperse those funds, and that’s easy if we’re giving them credit for the $4 million that they’re coming in with.
“If they already own the property, a lot of times the borrowers have already spent some money on it, so now we’re doing a refinance to reposition the property to build it for cannabis use,” he added. “The first step would be getting the closing statement from the previous acquisition, to verify how much money they put into escrow to close that transaction. If it was $5 million again, and let’s say that they put in $2 million and the lender put up $3 million, we would give them credit of $2 million, even though it’s already happened.”
That acknowledgment is a cornerstone of the model. “We’re going to give them credit for that because we call that skin in the game we can verify,” explained Sechrist. “And we source that, we look at the closing statement, and we verify where that money came from. If it didn’t come directly from the principles themselves, and if it came from a third party, we need to verify the terms of that money, and we need to have them be responsible for it potentially as a co-guarantor on the loan. Because if the borrower didn’t put the money in themselves, which we refer to as skin in the game, then it’s not as important for them to be successful as it is if they earned the money themselves.
“That’s a very important part of our process, making sure where the capital came from,” he added. “We do trace that money, and if the money came from somebody else, what are the terms? Did they buy into the company? Are they an equity owner? Do they have a vote? How is it structured? We collect and verify all those documents and we do that for every single dollar that was ever raised for the property, including cap tables and all of that.”
Does this mean that your model might have a heavier expense up front than other models, but that it’s much easier term-wise, as well as other incentives? “An equity REIT doesn’t have to do any of that stuff at all,” replied Sechrist. “Because they are a buyer of the property, they are not looking at verifying the dollars. What they are looking at is the value of that property in today’s market, what is the right lease-rate to earn back the entire purchase price that they’re going to pay for this property over the next 15 to 20 years, and what does that credit risk look like?
“We say that an equity REIT sales leaseback is effectively a synthetic 100 percent loan-to-value transaction,” he added. “What’s happened here is that all of that skin in the game that they had previously for a lender, you just cashed them out. And so now they have no incentive over the next 15 to 20 years – which is the typical term – if there becomes a disparity between the base lease rate that they wrote in year one with a two to three percent escalator and where things are at 15-20 years later. If the cost of capital comes down too much in the sector, or if cannabis becomes federally legal and you can now ship across state lines, that lease may no longer be economically viable when you compare it to another state that has significantly lower employment costs, tax rates, and all kinds of things.”
It is a circumstantially flawed model. “How can you possibly have an industry that has no sales comps, and no company has been profitable for a sustained-enough period of time to establish any base rates,” asked Sechrist rhetorically. “Plus, you still have the regulatory changes and headwinds that are still evolving, and no state has reached a fully stabilized market yet, so how can you possibly set that lease rate to work all the way through the next two decades? It’s going to be impossible, and what we prognosticate is going to be a potential issue with the sales leaseback model – which is a great model for an established mature industry with no regulatory risk, and there’s market comps for decades, if not hundreds of years – is what happens when the lease is becoming so expensive relative to other visible properties and leases? You’ve already cashed the tenant out, so they’re just going to say we’re out of here, we’re not going to pay the lease, sue us, and then they’ll go into litigation for that.
“And that is the reason we think lending is a better model for borrowers in an emerging market from both a regulatory sense and also the development of each cannabis market within each state,” he concluded. “At some point, you will be able to cross state lines, whether it’s this Congress or the next administration. That will change the landscape as well, and there’s a reason that the majority of wines come out of Napa and not from all the way across every single part of the whole country. That’s where ultimately there was the best quality product, the most infrastructure, and the knowledge base, and that landscape will change for cannabis as well once we have the ability to cross state lines. When those things change, all those leases may or may not be as economically viable as they once were.”
The temptation to go with some models is strong, however. “For a borrower who has a loan, if the economic conditions change they can always refinance and go to a lower cost,” explained Sechrist. “That’s the advantage of owning your property. The disadvantage is if the property value goes lower, you may never get what you would have gotten from the sales leaseback buyer back in the day. So, in cannabis, the incentive to sell your property is enormous, because you were able to put together a liquidity event to free up capital without having to sell any of your stock, and in a capital-starved industry, that’s the Holy Grail. Now, it is much more difficult to get into a loan because you have to come up with that equity, but you had to come up with that equity as well for the sales lease-back at a certain point. At one point, most transactions for sales leasebacks probably already had debt on them, so in our model you’re freeing up that $4 million to be put back into the business, and that might be the least expensive capital you’ve ever put together. But most cannabis companies are willing to take the risk of the disparity of the lease rate over the next 10 to 15 years because they are more focused on near term cash-flows.”
The Pelorus Analysis
Sechrist noted there are several elements to Pelorus that make it unique in the industry, including one that was mentioned in that same interview with Travis Goad. “We have our core of lending, and that is a very special skill, but all lenders have that to more or lesser degree depending on their expertise,” he noted. “What makes us unique is that Pelorus was the first in the entire country to analyze the cannabis sector related to real estate. And why that is important is that all the metrics and everything that has been analyzed prior to us being here was from the cannabis operator or business side. They’re looking at taxes, they’re looking at product sales, they’re looking at the revenues generated in these states. And they’re looking at the company’s or operator’s viability. Because they didn’t exist, nobody was tracking what cannabis properties were valued at, or what the lease rates were. In any normal real estate asset class, you can go to REIS or CoStar or any one of these third parties and you can pull comps, whether they’re sales comps, or lease comps, or you could pull market metrics. But that doesn’t exist for cannabis because those properties didn’t exist before.
The solution was right in front of them. “We realized that not only did we need to understand the real estate to do that,” said Sechrist, “but we also needed to understand it in conjunction with the cannabis operator businesses, i.e., licenses, so we mapped all of the approximately 40,000 licenses across the country, and we update it every month. Today, we know every license holder in the country, who owns it, what types of licenses they have, where that cannabis business is physically located, and do they own that property, or do they not own that property? We were the first to realize that once this market is fully built out for all 50 states, the real estate side is about a $50 billion asset class just for the real estate, not revenue. And why that’s important is that you need to understand each of these markets to understand whether you’re going to lend in them or not.”
Sechrist was taking a very long route to answer the question for a reason. “I think it’s important to understand that because it’s not just Massachusetts, but any state. We need to understand what each state’s maturation to a fully stabilized market is. In any new state, there is generally enormous demand because there are few producers on day one, and you can sell any type of product with no problem, and the next year you get a bunch of competition that comes in, and you get oversupply. It may take more than a year, but generally you get under-supply, then oversupply, and then the market will eventually work itself to a stabilized market.
“There are a lot of variations to that because an unlimited license state will have a different evolution cycle than a limited-license state,” he added, “and a medical-only state will have a different evolution cycle than a state with medical and recreational. That’s important because we know that to really understand the real estate, we have to understand the cycle, or what we term the maturation. As the market matures within that state to a fully stabilized level at some point, all 40 million people in California are going to be smoking the most percentage pot they’re going to be smoking per day, per week, for a year, and the universe of dispensaries is going to be established and it’s going to eventually settle down. There’s eventually going to be a stabilization of what the price is for different products within each category: flower, extractions, edibles, and beverages, and a market share for each within each state, and what you don’t want to do is to produce another million square-foot facility if there’s already too much capacity in that state.”
Tracking and analysis become indispensable. “We know for example that Colorado has too many dispensaries per capita, and that there’s going to be a reduction in that, and we can pull and extrapolate that data from the data analytics we have,” said Sechrist. “We operate a separate company we own that does that, so we are the first to be thinking about things in that way as it relates to real estate.
“In reality, we probably understand the market better than any cannabis MSO,” he added. “And even if you’re one of the largest ones out there with a multibillion-dollar market cap, you only have your own numbers, your own thought processes, your cultivation, your dispensaries, the things that you have. And let’s just say they are massive, and you have hundreds of dispensaries, and let’s say that you have dozens of cultivation sites, and co-packing or whatever it might be at all the facilities. In reality, from the whole market size, it’s infinitesimal.
“We see it from the entire universe of the market, and we are tracking that on a monthly basis, not only from the universe of everybody, but also from our own borrowers,” he noted. “And we are pulling that information in on a monthly basis, and we’re analyzing the mean of what should be the normal costs for this geographic area for this type of product. It’s across multiple different regions and multiple different companies, multiple different thought processes that everyone is using, and by having that disparity in the differences of the climate, the location, and the way that they are doing things, we’re able to start seeing things shake out about what’s actually working best and what’s not, in real time, faster than anybody else in the country. And we have taken that data, established the means, anonymized it, and now we’re putting that back out to our borrowers to help them be more efficient.”
In a similar vein, cannabis demands a level of expertise not required in other industries. “When you’re a lender on a drugstore or a hotel, you don’t need to be an expert on being a pharmacist or a hotelier,” said Sechrist. “But cannabis is so special that we actually had to become an expert. We don’t tell anyone how to run their business, but when they provide us with their information to underwrite their loan, we have such a large robust data set that we can tell them. ‘Look, we think that your numbers could be better, and the reason why we think they can be better is that we think you could save 80 percent in labor on trimming, and the reason we think that is because it’s already been proven across all of our other borrowers from this particular methodology. You’re not required to do it, but this is how they’re doing it, and we would strongly suggest going and touring one of our other facilities and making that decision, because it adds right to your bottom line.’ Or we might say that you’re still using old technology, or that you’re not using any technology in this particular sector, and you may want to consider using it, because we already know that it is going to improve 20 to 30 percent of your yield just by doing this one thing. These are real numbers when you have a cannabis crop that is costing several hundreds of thousands of dollars every week. Any percentage increase matters, and when you start picking up 20 and 30 percent at a time, those are millions of dollars.”
Asked about the state of demand for lending, Sechrist said it was off the charts. “It’s more so now than ever because so few people are able to lend in this macro banking environment,” he explained. “Lending is always going to be there. Even when the market is fully stabilized, there’s always going to be properties that need to be repositioned, new buyers for things. But at this stage of the market of a $50 billion asset class that is going to be built over time, we’re just getting started with all those build outs. So, we have a long runway until the vast majority of all that has been completed, and once it’s even completed, stuff will need to be refinanced and repositioned every few years.”
Lessons From Canada
It turns out that Canada as an example of a federal system regulating cannabis served up some lessons for Pelorus. “Just so you know,” said Sechrist, “we also mapped everything in Canada. Even though we don’t lend there, the reason that we did that was to have a dataset that shows some aspects that we might be able to utilize from a national perspective.
In Canada, each of the territories or provinces have their own rules, so it’s kind of a hybrid model. “Yes, but there’s a broader problem with what happened in Canada,” said Sechrist. “Regardless of whether it’s a hybrid national model or whatever it is, the bigger problem is that cannabis-use properties are enormously expensive to build out, and they’re enormously challenging to get right and to fine-tune every time that you can fine-tune it. Even if you pick up a one-percent efficiency, that’s just getting added to the bottom line, but if you can keep picking up a percent here and a percent there, that 5 percent starts adding up to real money. The issue is that capex is so expensive to come up with, and generally you’re having to raise it at the worst time, because you don’t have the benefit of the cash flow from the property that you’re making the speculative investment in yet, so the Canadian operators all went for scale and market share.
“The bigger problem up there was that you have never had cannabis facilities built at that size, and so you were basically taking your all the capex that you’re using to make an investment in this industry, and in a rush to gain market share you blow it all to build the biggest facility you possibly can. And when you were looking at dollar cost savings, dollar cost averaging, and dollar cost in everything in the modeling, the modeling only works if the facility is actually working. So, what happened is that everybody built these facilities when they didn’t know what the cost would be. They had a budget, but you don’t know what it is until you’re finished, and the cost overruns, the time overruns – and time is a cost as well, because you have to keep everybody afloat for those additional months when you had no revenue coming through.
“So, basically what happened is that instead of building a very small facility, making sure it’s working, and then scaling that up sequentially in reasonable amounts as it works so you can get bigger and bigger and bigger over time, instead they tried it all at once, and it didn’t work, they built them wrong, they blew all their money, and they only realized after they got it completely built that it doesn’t work, and it’s never going to work. And so now it’s actually going to cost more money to retrofit an existing property that was built wrong than to go build it again.”
Weren’t people also building for market share and scale for years in the U.S.? “That lesson that I mentioned for cannabis in Canada is true for any market, any category,” replied Sechrist. “It’s exacerbated for publicly traded companies, which are raising capital and giving forecasts based on market share and growth, as well as profitability or non-profitability, and for companies that are not going to be profitable for years, the fastest way to get them to profitability is for market share and scale to show that they’re going to get there faster by creating the scale faster.”
It’s a different scenario for private companies. “Because they are underwritten by individuals, private companies are not necessarily looking to go as big and hard as possible,” he explained. “The underwriting is coming from individuals that have more data to make that decision as opposed to retail investors that have basically a press release to make their decision from. And so privately underwritten transactions or private companies are generally going to go through that process better than a publicly traded in an emerging industry, but it does happen. To some extent, it’s hard to not do it when you feel as though the entire market is moving past you, and it’s hard to hold back and try to grow slowly and methodically and keep your gunpowder dry. Even your private investors would be frustrated with you. ‘Why are you not moving faster. We would like to see returns.’ So, it’s a tough situation to be in, but when you’re privately held, you have more ability to communicate with those few investors and tell them what you’re doing as opposed to a publicly traded company and you’re getting downward pressure on your stock price.”
Flying Under the Radar
Through luck and skill, Pelorus has avoided the Canadian pitfalls over seven years. “None of our facilities or markets have been overbuilt,” said Sechrist. “In the beginning, we didn’t have the same knowledge base that we have today, so just by nature we didn’t get into that size and scale of transactions. What we learned a long time ago, and why we built the data company, is that we need to have more information about not only the business economics of how these businesses are run, but contemporaneously we also need to know how that state is going so that we can understand not only the cannabis business operator within that state, how they are doing, but where does the particular business fit within the universe of the particular state and where that state is at. We realized in this particular sector that we needed to have more data to understand the market better, because what might have been the right sizing in place at one time may not be the correct sizing in the future of that same market or that same facility.”
Goad in the October article had said that the sweet spot for closing loans was in the $10 to $30 million per transaction range, that Pelorus can fund loans $100 million-plus and as low as $5 million, and since 2016, it has financed 4.2 million feet of cannabis properties for a total of $468 million in loans, or roughly 15 to 20 percent of the entire US market.
“Yes, that is still the framework that we’re in, and I doubt that we would get much further away from that,” said Sechrist. “We generally don’t go less than 5 million, but we have the ability to go bigger if we want to, and when we do go bigger, it’s typically a portfolio of lots of different properties. Our largest transaction is across multiple different counties and multiple different properties. So, that is segregating and breaking that risk apart, and each of those properties is part of a larger, broader portfolio that we’re underwriting.”
Generally speaking, commercial space use for cannabis-related use still demands a premium because it’s cannabis. “Just remember that the highest and best use for a property licensed for cannabis is going to be cannabis,” noted Sechrist. “In general, cannabis-use properties have the ability to do up to ten times the revenue of a non-cannabis property. But conversely, it takes ten times the amount of capital cost potentially to build it out for that purpose, and maybe more.”
Is stress added to cannabis commercial real estate markets when MSOs start abandoning them? “You’re going to have distressed operators for all kinds of different reasons,” said Sechrist. “You could have an amazingly good market, but the operation is not being run efficiently, or they had bad luck. Agriculture is one of those things that is so temperamental – bugs, pesticides, compliance; you can have a crop that gets wiped out, and you might not have enough reserves to get another crop out before you go under, so it’s enormously challenging. That’s more of an issue for outdoor crops because they typically only do one crop a year, and if they get it wrong or if it doesn’t pass compliance or whatever, they are screwed. There are always going to be distressed transactions and distressed properties out there, but remember, a distressed transaction for one person is a massive opportunity for somebody else.”
Has there been any change in the type or scale of real estate deals people are putting together? “I’m not aware of any broad changes,” said Sechrist. “Some of our lending peers only do very large transactions or syndicate with other lenders to do large transactions that are primarily limited-license state transactions with multistate operators. But we believe that you have got to have a blend of unlimited license and limited-licensed, both privately held and publicly traded, in all different sizes of transactions, to really mitigate your risk across the board.
“We’ve always had a broad approach to that,” he added. “Now, one of our lending peers has said that they would never go into an unlimited license state. Why would they do that? And it’s my understanding that they have originated their first transaction in an unlimited licensed state or are about to. So, you can see that that thesis isn’t going to work so well when you’ve got the possibility of cannabis becoming federally legal. You have to jump that bridge at some point, so I think it’s a very bad strategy to start with.”
Are more institutions getting into the lending game in cannabis? “There are 684 banks listed on FinCEN’s website that are cannabis friendly and had processed suspicious activity reports (SAPs) for cannabis, and we’ve heard that as many as 400 of them have done lending or participated in lending, and we’re tracking a dozen of them,” said Sechrist. “There are state, federal, and community banks across the country, and credit unions, that are lending. Typically, these banks do smaller balance size loans of $1 to $5 million. State banks or community banks are also generally regional to their area, and they can only put so many transactions on their balance sheet before they get to what’s called the concentration limit, so they can only do so much.
“As a private lender, we can do what we need to do to make the transaction work as long as it’s within our risk profile,” he added. “Banks don’t have that ability because they’re under regulatory controls, so they’re going to get to a certain point where they’ve reached their borrowers’ concentration limits on geographical location. Just think about it. If you’re a bank that’s lending to the wine industry, and you have a 20 percent geographic limitation in any one particular region, but Napa is where all the best wines come from, what good is that going to be?”
The Lending Landscape
I mentioned to Sechrist that it’s often difficult to square competing narratives in this industry. On the one hand, there’s no capital, no one has any money, they can’t pay their taxes, no one’s making a profit, and it often comes back to that lack of capital. In the other narrative, there’s plenty of money to lend, but the terms are difficult right now. What’s wrong with this picture?
“First of all, you hit it on the head earlier,” he replied. “There are companies that are doing well, there are companies that are profitable, but you just don’t hear from them. You only hear about the stories of, ‘if it bleeds, it leads.’ You only hear about the bad stuff. You don’t hear somebody tooting their horn that they just had a record month or record year in a particular state or region or company unless they’re publicly traded, and then they have to report that they’re flying under the radar.
“Capital is tight because what people don’t realize is that the entire U.S. capital base, even though there’s publicly traded companies, is only retail investors, which is infinitesimal on over the counter, publicly traded or Canadian-traded stock exchanges,” he continued. “Until you have institutional capital in the sector, it’s almost a nothing burger that these companies are public. It’s all gone public on the basis and the hope that they would be able to get to the bigger exchanges in the near term. Well, that never happened. Now, it might happen in the near term potentially, but that hasn’t happened for years and years and years, and so you have very little capital from these retail investors striking the entire market.
“And it’s very, very thinly traded, so you get these massive swings in capital, so there is not the depth of capital,” he added. “The other thing is that the retail investors made investments and pushed those stock prices to heights so disproportionate to what any private underwriter would have done, that then you couldn’t bring in regular capital until later because it would have written down the market cap of the company. Well, today that’s all come home to roost, but most people don’t realize that that was the case, or don’t think about it that way.”
It is for these and other reasons that Sechrist and the Pelorus team are such active proponents of passage of the SAFE Banking Act. “There were only a couple of companies that can trade on the broader stock exchanges, and those are all real estate related. There’s IIPR on the New York Stock Exchange, and a few that are on NASDAQ, but the ones that are on NASDAQ have some limitations that they had to give up in order to be listed on NASDAQ. Until you get legislation that passes that allows these companies to be listed on the bigger exchanges so that institutional investors can come in, you’re not going to have that flow of capital. I do think that at some point that will happen, and it may or may not happen overnight, but over the next half a decade this will become a real industry, there will be institutional investors, and it will all shake out.”
The company’s beating heart is the Pelorus Fund, which reportedly grew by 41 percent in 2022 while outperforming the benchmark cannabis ETF by 84 percent. “Let me talk about that,” said Sechrist. “Pelorus could have been the first company to go public in the sector. We were the first dedicated lender, and we chose not to for a couple of reasons, including that there’s no institutional capital, and we can’t be on any major board. And to get on the NASDAQ like some of our peers, most people don’t know that they are not able to directly foreclose themselves or own any cannabis related business entities directly or have any equity kickers. So, if you’re a lender on a specialty use asset, you’re generally going to be the most experienced and the one that needs to be repositioning and utilizing all those relationships that you have, as opposed to having to go through an unrelated third-party to do that. And we didn’t think that there was an advantage to doing that at that time.
“The other thing is that you also have a lot of volatility, and your share price could be up, but it could also be down,” he added. “We’ve always said that this asset class is less impacted by a real estate or economic downturn, and so if you have an asset class that’s going to do better than other traditional assets in real estate, why would you want to be publicly traded and have that downward pressure that is not coupled with the true economics of your fund just because the macro markets are being broadly affected?
“That was why we chose to remain private, and it gave us more flexibility,” he continued. “By being private, we believe the Pelorus Fund has the most flexibility and the ability to foreclose directly, own assets directly, both property-co and operator-co if we needed, because we believe that you cannot maximize the value of any cannabis-use real estate without collateralizing the license, and if you collateralize the license, and you can’t foreclose on that license and own that license, how are you possibly going to be able to give that real estate the highest and best use?
What is the Fund’s future? Even when institutional money arrives in a big way, it sounds like the Pelorus Fund is designed as a boutique firm that could do extremely well in any environment. “Yes, that is true, and we believe that that strategy will play out,” agreed Sechrist. “Now, I can’t tell you that in 10 years, when we’ve got multiple billions of assets under management, that there might not be a reason to go public at that time.
“We just don’t see that as being an advantage today, and there’s also a difference between equity REITs and debt REITs or mortgage REITs,” he continued. “An equity REIT is a very popular publicly traded stock, and the reason for that is that you get the appreciation of the real estate over time and given enough time generally all real estate goes up, or at least the value of the dollar goes down, which makes it looks like the real estate went up. But in addition to that, you get the depreciation of the real estate passed through to the individual investors. And so, to get those two benefits of an asset, that’s generally going to be inflation proof, and to get the tax write off of the depreciation of the real estate, with some cash flow, is a very compelling publicly traded stock equity to have.
“Conversely, a mortgage REIT doesn’t own the properties,” he added, “so they’re never going to get back more than the loan that they put out. The only appreciation you get is synthetic through the yield and is coming from the note. And so, in theory, a mortgage REIT stock should never trade at a premium more than a discount to what the next quarterly distribution is for the estimated earnings. Most retail investors don’t even realize there’s a difference between IIPR and some of the other mortgage REITs out there because it only says REIT. They just see that these other REITs have a significantly higher yield, and the reason they have a significantly higher yield is because it’s all coming in off a coupon off the note rate, and there’s no other pickups there.”
Indeed, the plethora of misinformation that plagues the industry is another core focus for the Pelorus team, which sees education as a requisite for creating a mature cannabis industry. “We actually took a proactive approach, and unfortunately it was half a decade too late,” said Sechrist. “We didn’t realize how bad it was until we started doing bigger and bigger transactions. We were kind of in our own universe of doing our own small transactions, but as we became bigger players in the industry, doing more conferences and meeting more people, we began to realize how much retail investors didn’t understand the market that they were investing in. And so, we have taken a proactive approach with our educational series, and now we educate anybody about the sector. We try to inform them as much as possible through our channels on Twitter, LinkedIn, and Instagram, and we have our own educational series on YouTube. We also do shows on The Dale’s Report, because they’re focused on equities and have been in the game for a while, so we started coming on their show to provide information that these retail investors never knew.”
Big Lending
Curious about M&A activity in the cannabis lending space, I asked Sechrist if lenders like to buy one another. “They would potentially if you’re trying to cobble up market share,” he answered, “but there’s really only three large-scale lenders in the sector, and of those three, the two publicly traded ones previously mentioned have a different lending model than us; there’s such a disparity that we could never take that book risk as a company for an acquisition of them.
“One those two already is exiting the market, so they’re not a player,” he added. “With the other one, I don’t know if their personal background is operating or lending, but lending typically goes through cycles, and the last thing you want is a massive staff that you have to support. And that’s why, when the interest rates started going up a year ago, you saw a lot of lenders just simply shut their doors. The reason they did that is because without originating new loans, they had no way of paying their staff.
“Our company is structured so that we keep the minimum number of key employees that we can sustain with our existing loan book,” he noted. “We do not need to originate a transaction ever again and we will be fine. Most lenders are not set up that way; they must originate and collect that origination fee to stay alive, because they do not keep the loans on their own balance sheet. We keep all of our own loans on our own balance sheet, and so we’re able to utilize those assets in our loans, and then the way that we’re structured, it’s here to survive, no problem.”
A map on the Pelorus Fund webpage shows the current state-by-state status of legalization. Fully legalized states dominate, but it’s a patchwork, and only five fully illegal states remain. Does that mean we will see a diminishing pool of potential borrowers for ever-smaller commercial build outs as the cannabis industry matures?
“There’s going to be $50 billion worth of real estate assets.,” reiterated Sechrist of the mature industry he envisions. “That’s a sizable market, and all of that $50 billion had to start off as a construction loan, because even if the property existed, it had to be built out specifically for cannabis use. Once it’s built out, then it’s refinanced into a lower cost, fully stabilized loan, but it’s a longer term. So, the genesis of all of the new states always starts off with construction or bridge lending to reposition those assets and build them out. The next phase is that they are refinanced at a lower cost, and then once the market has stabilized, the velocity of transactions will no doubt slow down. But it’s still a large enough market that at any one time there will be more than ample new transactions of properties that might exist that are being retrofitted and optimized to be more efficient, and transactions that are taking equity out and refinancing for cash out or lowering their rate.
“There will always be loans going on,” he added, “but the velocity of the construction bridge loans always starts in any new emerging states as the primary loan, and then eventually goes to the fully stabilized loan. We believe that most of our book is about 75 percent bridge spending, and 25 percent fully stabilize, and we believe that that will eventually go to about a 50-50 mix, and then we believe it’ll go to probably 75 percent fully stabilized, and 25 percent bridge.”
The commercial cannabis real estate situation in Massachusetts once again flashed through my thoughts. “I will just tell you this,” said Sechrist. “We have a borrower in that same state, and they are covering our debt service coverage ratio; before they even got up, all their facilities operating was 5x, and it’s going to be 8x once they’re fully stabilized. There are people that are doing enormously well in all these markets, but again, they’re not the ones you hear about. It’s the guys that mess up and need to say that the market’s not working and that it’s not their fault to get that coverage. But even in a bad market, even in California, outdoor wholesale is roaring back, there’s going to be a massive under-supply this year for numerous reasons. So, we believe that all these markets are up and down on the pricing on a general trend up, and you need to be able to sustain yourself through those down markets to get through to the next side.
It sounded as though they had also figured out how to make Pelorus sustainable no matter what happens in the market. “That’s correct,” said Sechrist. “We’ve been working in lending for a long time, and we’ve thought our way through that. If we’re going to be long-term players in this, we had better be able to underwrite unlimited license states, and we had better be able to underwrite privately held smaller companies and not just rely on big market cap companies, because there’s only so many of them out there, so we took a diversified approach to all of that.”
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