When Marilyn Kane seeks out commercial properties for her clients to acquire, drugstores are high on her list. The founder of New York-based fund manager Iridium Capital, Kane works with investors who lack the capital or skills to operate income-producing properties. By pooling their financial resources, her clients can acquire low-risk real estate that requires minimal management.
Drugstores fit the bill. Usually leased to high-credit tenants on terms that can stretch from 15 to 25 years, these largely homogenous properties provide steady returns, low risk and a ready exit strategy when it comes time to sell. Leases typically are written on a triple-net basis, so the tenant manages the property and pays for maintenance, insurance and taxes.
“The new buyer will have a secure tenant whose corporation is guaranteeing the rent,” says Kane. “As a landlord seeking a tenant, these investment-grade companies are good bets.”
Safe bets, that is. Unfortunately for growth-oriented investors, the predictable value stream from a drugstore lease leaves little room to boost income over time because lease agreements nearly always dictate when, and by how much, the rent will increase.
That’s OK with Nicholas Schorsch, chairman and CEO of Jenkintown, Pa.-based American Realty Capital. The company’s non-traded real estate investment trust (REIT) recently purchased 35 CVS/pharmacy stores in two portfolio acquisitions collectively worth $100 million, according to New York-based Real Capital Analytics.
“Drugstores have morphed into more than the classic pharmacy we grew up with,” says Schorsch. “We like that the use of the building is becoming more and more of a general store.”
Pharmacy sales are an obvious customer draw, but the sector generates additional sales from convenience shopping and services, such as printing digital photos.
“You can buy pretty much anything you can buy in a grocery store, and medication and a variety of sundry items,” Schorsch says. “If you look in the beach communities and resort towns, you can even buy clothing and beach chairs in some drugstores.”
The appeal of drugstores for investors boils down to the three Qs: quality income, quality location and quality of the business model, says Schorsch. Roughly 14% of American Realty Capital’s portfolio is invested in drugstores including CVS/pharmacy stores, Walgreens and Rite-Aid stores.
American Realty Capital buys single-tenant, net-leased properties. “So it fits a lot of the aspects of our portfolio.”
Drugstore real estate sales totaled $1.53 billion in the 12 months that ended June 30 and accounted for 10% of U.S. retail property sales, according to Real Capital Analytics. At 7.6%, the average capitalization rate — or initial annual rate of return on drugstore acquisitions based on purchase prices — was 40 basis points lower than the average for retail as a whole.
Development has slowed but acquisitions and consolidation in the industry are brisk. Just last month, Walgreen Co. (NYSE: WAG), based in Deerfield, Ill., announced plans to acquire 18 ApothecaryRx pharmacies in Colorado, Oklahoma, Minnesota, Missouri and Illinois from Graymark Healthcare Inc.
In previous deals this year, Walgreens picked up more than 50 drugstores through similar portfolio purchases that included Super-D drugstores in Memphis, Eaton Apothecaries in Boston, Snyder’s Drug Stores in Minnesota and El Amal pharmacies in Puerto Rico.
Walgreens’ largest acquisition this year by far, however, closed in April when the chain purchased all 258 Duane Reade stores in New York City, along with Duane Reade’s corporate office and two distribution centers.
CVS Caremark Corp. (NYSE: CVS) opened 50 drugstores in the second quarter alone. The Woonsocket, R.I.-based company operates more than 7,100 CVS/pharmacy and Longs Drug stores. CVS also has been one of the largest sellers of its own drugstores.
In fact, drugstore companies were the sellers in 75% of sales by dollar volume over the past year, according to Real Capital Analytics. That explains how investors have been able to find drugstores for sale despite curtailed development pipelines.
The largest chains are liquidating real estate through widespread sale-leasebacks, in which the company sells properties to investors and then leases the same assets for its stores.
Walgreens owns about 20% of its stores and leases the other 80%, according to Joe Brady, managing director for retail leasing in the Chicago office of full-service commercial real estate firm Jones Lang LaSalle. CVS, the main competitor, leases 96% of its locations, he estimates.
With the majority of drugstores already sold to investors, the supply available for acquisitions is smaller than it was a few years ago, Brady says. That has investors vying to buy assets and bidding up prices.
Credit drives up prices
Sales of drugstores fetched an average of $442 per sq. ft. in the 12-month period that ended June 30, according to Real Capital Analytics (see chart). That’s up 2% from a year earlier, and compares with an 18% drop to $180 per sq. ft. for general retail during the same period.
Ben Carlos Thypin, senior market analyst at Real Capital Analytics, attributes those high prices largely to the value investors place on dependable long-term returns.
The trend of the largest chains absorbing local and regional operators has enhanced the drugstore subsector’s appeal to investors, he says. Major chains with excellent credit ratings now occupy the majority of U.S. drugstores.
“Whether you are investing in a fund that buys these properties or buying one directly, you are basically buying a corporate bond,” explains Thypin. “You don’t have to do any management; you just sit back and collect your return.”
That credit quality isn’t lost on lenders, either, according to Brady of Jones Lang LaSalle. He has seen non-recourse loans approved recently for drugstore deals between 5% and 6% on seven-year terms based on the credit quality of the tenant. “That’s a phenomenon we’re not seeing in other real estate.”
Walgreens has the highest long-term credit ratings of the three largest drugstore companies, with an A2 from Moody’s Investors Service and A+ from Standard & Poor’s. In September, Walgreens reported an 11.4% increase in earnings per share, thanks to a 7.4% increase in fourth-quarter total sales that brought its fiscal 2010 sales to a record $16.9 billion.
CVS carries ratings of Baa2 from Moody’s and BBB+ from Standard & Poor’s. The company reported declining sales but is still projecting healthy earnings of $2.68 to $2.73 per share at the end of its fiscal year.
It’s a different story at Harrisburg, Pa.-based Rite Aid Corp., which has struggled to manage its debt and is projecting a net loss between $400 million and $590 million this year. Moody’s rates the company’s debt at Caa2; Standard & Poor’s gives it a B-. Real Capital Analytics found that investors differentiate between brands and pay the highest prices for CVS-occupied stores.
Private buyers predominate
What drives investors to pay premium prices for drugstores? Most drugstores sell for between $6 million and $10 million, and that makes them popular among investors looking for their first real estate acquisition, according to Kris Cooper, managing director of retail capital markets in Jones Lang LaSalle’s Atlanta office.
“If you buy CDs (certificates of deposit) or put money in a savings account today, you’ll get very little return,” Cooper says. “But if you can get a 6% or a 7% return for 20 years, there’s no question, you want to invest in a Walgreens.”
It’s no coincidence that American Realty Capital, one of the largest drugstore buyers of late, is also a non-traded REIT. Because non-traded REIT funds are designed around a liquidity event — usually a sale — the ability to sell assets is a priority, explains Thypin of Real Capital Analytics. He notes that in the past year, 76% of drugstore asset sales went to untraded REITs or private buyers.
“The top buyers of these properties are non-traded REITs; they distribute most of their income so they need relatively liquid assets,” says Thypin. “Drugstores provide a very liquid asset class of real estate, perhaps even the most liquid.”
For all its merits, the drugstore sector harbors pitfalls, especially for developers, says Schorsch of American Realty Capital. For instance, drugstore construction is expensive and leases allow little room for rent growth to cover any underestimations of cost.
The cost to acquire the easily accessible, high-traffic locations that drugstore operators demand can be prohibitive. Because site selection is critical, Kane of Iridium Capital prefers to purchase drugstores where the tenant selected the site based on its own analysis.
“The investment in this type of single-tenant, net-leased property mitigates so much of the volatility inherent in real estate,” says Kane. “Net-leased property, we feel, is as good and comfortable an investment as an investor can have.”
Matt Hudgins is an Austin-based writer.