What happens when Toys for Tots meets marijuana

I recently read an article in the Denver Post that the nonprofit Toys for Tots is unable to locate warehouse space for their annual toy drive. I knew why without even reading the article.

The Denver warehouse market is on fire as a result of one major factor: marijuana.  The legalization of marijuana has sent Denver warehouse space through the roof.  As a lender, I am seeing this first-hand. I was recently asked to lend on a large warehouse in metro Denver. I pulled up the history: In 2010, it was marketed for $2.5 million, and it did not sell.  It is currently under contract for more than $8 million to a marijuana grower. This represents 320 percent appreciation over a 5-year period.

So what does marijuana have to do with Toys for Tots? The most desired space for marijuana (whether it is a grow operation or manufacturer of infused products) is industrial space. Industrial space is typically not close to residences and has the proper zoning, electricity and security. This has led to a surge in demand for industrial space by the marijuana industry.

The marijuana industry actually wants many buildings that were in the past functionally obsolete and not leasable. Marijuana tenants are able to use space with lower ceiling heights, no dock doors, smaller manufacturing areas and a higher percent of office versus warehouse space. This is much of the same space that in the past might have been donated to a nonprofit or leased at a very low rate since there was very little demand for this type of space. With the marijuana industry absorbing this space at premium rates, Toys for Tots has been left out in the cold.

With vacancy so low, prices are now increasing for all users of warehouse/industrial space throughout the metro which leads me to believe we are at or near a peak in the industrial market and the market could get interesting quickly.

As a result of the quasi-legal status of marijuana (legal in Colorado but illegal under federal law), building owners are getting a premium for marijuana space due to the “risk factors” (whether perceived or real) involved. Marijuana tenants are typically paying considerably more (sometimes two to three times) what a normal user should pay.

So how does this lead me to believe that the industrial sector is near a peak and could get into trouble? Basic economics will always prevail.  As more marijuana producers come into the market, the price of the product will decrease. With lower prices, margins are compressed and providers will be less able to afford the premiums on their space.

There is further supply pressure as illegal grows cut into the legally produced supply of marijuana. Over the past month, six large outdoor grows have been seized by federal authorities netting over 20,000 plants. I’m sure that the illegal growers sold a good portion of their product before being discovered which further increased supply.

So from economics 101, as supply increases (assuming demand stays somewhat level) the price will decrease. As pricing decreases, marijuana growers will need to focus on their production costs, including their facilities. As a result, growers will seek lower cost alternatives.

Lower cost alternatives are available. Marijuana is an easily transportable product, so location is not as key (as opposed to a steel mill that needs to be close to its customers).  With that in mind, many growers are looking south of Denver to Pueblo and other markets. Lower cost is also becoming available via specialty greenhouses that are sprouting up now throughout the state. Why would a grower pay 10 times the price for a building in Denver when they can manufacture the same product in Pueblo or other low-cost region or greenhouse? 

This leads me to believe that there actually will be a decline in the industrial market. As more competitors enter the market, cost will continue to be a large business driver. It will be impossible for the current tenants to pay the above-market rents with the current decline in prices of marijuana. This will lead to them vacating less functional space they are utilizing for lower cost alternatives. With decline in rents, this will correlate to a decline in price via the income approach (a building is valued by the income it produces (net operating income) divided by a reasonable rate of return (cap rate). The sharp decline in rents will lead to a correlating large decline in prices.

The marijuana real estate gold rush has run its course, and Toys for Tots is the initial indicator for trouble in the industrial sector. The above-market rents and price gains are clearly unsustainable, and basic economics will ensure the sector comes back into balance. In a few years, Toys for Tots likely will not have as much of an issue finding space as the warehouse sector in Denver returns to normalcy.