Is Walgreens Leading Us Down the Yellow Brick Road?

Walgreens has been considered the bellwether for net lease properties, its high credit ratings (A2 for Moody’s and A+ for S&P) ensuring stability relative to the market. For the past year its cap rates have been climbing and many forecasted they would continue to rise till years end, however, recent developments may indicate that are cap rates leveling off. If Walgreens can be considered a bellwether for the market, this could point to wider implications.

Starting in late 2008 fears began to mount about the inflationary effects of governmental spending. The 25 year flat lease, customary on most Walgreens net lease properties, became increasing unattractive as a long term hold asset. Furthermore, the glut of properties on the market, 200-250 in 2008-09 compared to around 100 in 2007, placed upward pressure on cap rates. As a result Walgreens witnessed cap rates go from an average of 6.3% in Q4 2008 to 7.9% in Q3 2009. Some predicted average cap rates would exceed 8% by the end of 2009. However, as the year ended and we entered 2010, it became clear the upward motion of cap rates had ceased.

There is now a sense of stabilization in regards to Walgreens cap rates. It has been reported they averaged out at 7.5% for 2009, a far cry from the 8% some predicted. This could be because fears over future inflation have subsided and/or supply has decreased. Certainly there is a perception that the economy has taken a few steps back from the precipice of disaster encountered in 2008. Such developments could downplay the risk of inflation in people’s minds. It is also known that the supply of Walgreens has dropped substantially; there are now much less than the 200 or so properties previously on the market. This could mean that the market has already achieved stabilization through our current cap rate increases and now stands at a rough equilibrium.

Though it seems Walgreens has reached some cap rate stability, it is still unclear whether or not this applies to the rest of the market. There are still reports of large bid-ask spreads between buyers and sellers, so the net lease market has certainly not leveled out just yet. However, judging from Walgreens history as an indicator, it may not be far behind.

Warren Buffet's Logic Applied to Net Leases

Recently, Warren Buffet sent a letter to his stock holders in which he outlined six key points to his success. They are rather simple and based upon sound common sense; the trick is not in knowing them, but in applying them. As they are quite general in nature, they can also be applied to the net lease market, which after all, is just another form of investment.

Stay Liquid. Warren Buffet wrote:

"We will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses."

There are two simple lessons to be gleaned from this advice, 1.) Have cash, and, 2.) Ensure investments produce cash. While seemingly easy to follow, it is clear from the recent real estate and financial crisis that these principles are quickly lost. Overleveraging and risky investments can too easily entice people from the shores of sanity. When investing in net leases, ensure you are not overleveraged and that your investment is a sound, income producing property.

Buy When Everyone Else Is Selling.

"We've put a lot of money to work during the chaos of the last two years. It's been an ideal period for investors: A climate of fear is their best friend. . . . Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble."

This is pretty easy to understand but hard to follow. First of all its takes a considerable amount of bravery and foresight to run in the opposite direction as everyone else, secondly, it takes well planned fundamentals to ensure one has the cash to take advantage of the situation. However, for investors who do have the resources, allowing fear to inhibit investment opportunities defeats the entire purpose of investing.

Today’s commercial real estate market is obviously at a low point but those who insist on “waiting for the bottom” are in reality waiting for someone else to start investing first. In order to capitalize one must first mobilize and do so before the mob.

Don't Buy When Everyone Else Is Buying.

"Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance,"

Nothing is free. That includes “reassurance”, with which one buys off the cognitive dissonance of a decision. The most utilized source of this are the opinions of other people; we all care deeply about “what others think”. The price for this can be easily assessed in terms of cash, as demand increases price. Thus, the more people it takes to lend support to your investment, the more money you will pay for it.

Value, Value, Value.

"In the end, what counts in investing is what you pay for a business -- through the purchase of a small piece of it in the stock market-- and what that business earns in the succeeding decade or two."

When investing in commercial real estate it is very important to obtain an asset which produces value. There are many ways of assessing this, but stability over time is usually the most reliable. A few years ago, many would have rather owned an artificial island off the coast of Dubai instead of a less luxurious grocery store in a high traffic area; it is easy now to see which one time has judged the better.

Understand What You Own.

"Investors who buy and sell based upon media or analyst commentary are not for us,"

It is important to study the fundamentals of what you wish to acquire, with net leases this is especially important. Location, credit tenant rating, past returns, and lease agreements can all impact an investment tremendously. Before making an investment it is vital to understand its attributes.

Defense Beats Offense.

"Though we have lagged the S&P in some years that were positive for the market, we have consistently done better than the S&P in the 11 years during which it delivered negative results. In other words, our defense has been better than our offense, and that's likely to continue."

Aggressiveness can be a value but it must be paired with a secure end. There is no gain in being aggressive in a market which bottoms out. As Napoleon said “Take time to deliberate, but when the time for action has arrived, stop thinking and go in.” It is important to create a strategy which will provide in both high and low tides. Take the necessary time to pick the proper asset and then proceed forth with vigor.

How Will Retail Fare in 2010?

As 2010 gets underway it is inevitable the same questions which many had in ’08 and ’09 will be asked again. Concerns about the health of our economy, specifically retail, have not been resolved. Outright recovery is not forecasted and many are now predicting an extended economic quagmire. Since it appears likely the climate will be similar to last years, the companies that do well in 2010 will likely be the same that succeeded in the previous two years.

As reported by Shopping Center Business, the top three expanding U.S. Retailers in 2009 were: McDonald’s with 1000 stores, Walgreens with 554 and Dollar General with 500. These three companies perfectly illustrate that “value” is the biggest seller in today’s market. This trend has continued into 2010. In February Walgreens agreed to buy Duane Reade (257 drug stores) and the operator of T.J. Maxx and Marshalls announced “plans to nearly double its overall store count from just above 2,700 units to 4,200 locations”, with 130 new stores planned for this year. Dollar General not only plans to open 600 new stores this year, but will feature investor friendly lease terms as it moves away from its traditional modified double-net lease to a more favorable triple net lease. This will definitely be a crowd pleaser for net lease investors, who seek no landlord responsibilities and wish only to receive a monthly check.

While the 0.3% and 0.5% increases in retail sales respectively for December and January encourage the possibility that sales will significantly increase this year, it seems likely they will generally remain flat. With an average unemployment rate of 9.8% forecasted for 2010, many families will continue to place a preference on savings and value. This plays to the advantage of companies such as McDonald’s, Dollar General and Walgreens, ensuring their expansions will continue. Furthermore, a recovery may not necessitate a return to 2005 spending practices. Many consumers were badly burned through the over-leveraging which allowed for the high level of purchases seen in the “boom years”; this could encourage a long term preference for value.

In the past two years the most successful net lease tenants have been value tenants such as McDonalds, Dollar General and Walgreens. Their focus on affordable products has not only ensured survival, but allowed for great amounts of store expansion. With no indicator to say otherwise, it is likely this trend will hold for the duration of 2010.

Sweetgreen: A Fresh Dining Experience

Unbeknownst to many, an interesting new dining concept is springing forth in the Washington DC area. Sweetgreen is a modernly styled salad/yogurt restaurant, which caters to the ever-growing demand for healthier foods and is quickly spreading in popularity. It is headquartered in Washington DC and just opened its newest location in Logans Circle (DC) on the ground floor of the luxury Metropole residential condominium, across from the 15th and P Street Whole Foods. Currently it has four retail locations but its immediate success has encouraged plans for further store expansion.

The idea behind Sweetgreen is simple: a sustainable salad and yogurt bar with a chic atmosphere and unique dining experience. In the Washington DC area, this approach has established Sweetgreen as a leader in fast-casual dining by combining the convenience of fast food with healthy, high-quality menu options. Due to its favorable position, the owners think the new Logan location will be their best store yet.

The last twelve months have seen a surge in popularity of retail condominiums located in dense urban markets. Properties located in these areas, especially in the Washington DC urban core, are experiencing increased demand as they have prospered even in the face of the recession. Sweetgreen stands at the forefront of this trend, taking advantage of the current opportunities in the urban market to expand its presence. As highlighted by RE Business, many individual investors are drawn to urban retail because the size and price points often allows them entry to prime urban markets previously beyond their reach.

Retail condominiums are also a popular choice among many 1031 investors who are seeking suitable replacement property. The retail condo units are typically NNN meaning the tenant is responsible for all expenses associated with the property. The properties are actually easier for both the landlord and tenant to manage because the services required to maintain the property are already contracted by the condominium at large. The tenant simply pays the retail unit’s portion of the condo, management and maintenance fees.

Another potential benefit to investors lies in the assessed value of the property and the weight given to improvements and land. Since the improvements are a greater part of the overall value in a condominium it is possible to depreciate a significant portion of those improvements on a 15 year schedule through a detailed cost segregation study. That means a stronger return and more cash in your pocket at the end of the year. All of these factors make retail condominiums and some of their prime tenants such as Sweetgreen very attractive investments.

Net Leases Grow on Chains

It’s no secret that most net lease properties belong to nationally established retail chains. Among the more popular are McDonalds, Walgreens and 7-Eleven. Recently two more restaurant chains, Chipotle and Chick-fil-A, have shown they are poised for expansion. This should signify possible buying opportunities for net lease investors.

In the year ending on December 31, 2009, Chipotle experienced very positive results:

• Its revenue increased 14.0% to $1.518 billion


• Comparable restaurant sales rose 2.2%


• Net income increased 62% to $126.8 million


• Diluted earnings per share rose 67% to $3.95

For 2010, Chipotle expects its sales to remain steady and plans on opening 120-130 new stores. This expansion creates new investing opportunities with a highly successful tenant.

Chick-fil-A also had a successful year in 2009:

• Overall sales increased 8.6% to $3.217 billion.


• Same-store sales increase of 2.52%.


• Opened 83 new restaurants.

In 2010, Chick-fil-A plans on opening 78 new locations, also creating more investment opportunities.

Though many lament the current market, the steady expansion of many successful quick service restaurants has provided fuel for the net lease market. Chains like McDonalds, whose global same store sales rose 2.6% for January and Buffalo Wild Wings, who has experienced rapid growth, represent enticing opportunities for investment. Tenant growth and that of their applicable brands ensures products are widely dispersed and potentially adds the to staying power of those tenants. Those who have demonstrated steady, durable demand and will only attract more attention as they expand.

Urban Might

Wal-Mart and Target plan on developing smaller stores in order to penetrate the urban market. By decreasing square footage, entrance will be easier, allowing companies to take advantage of low prices in high traffic areas. This continues the recent trend of urban expansion, demonstrating the strong attractiveness of that market.

Typically, urban areas are associated with higher “real estate and fixed costs”, rendering big box stores somewhat ill-suited and clumsy. For retailers like Wal-Mart and Target, it was easier to move to locations more suitable for their gargantuan constructions. However, the wave of foreclosures which has washed over commercial real estate has forced prices down and tenants out, leaving many attractive properties in its wake. In order to take advantage of these opportunities, the traditional big box model has to be scaled down, with a focus on smaller, streamlined stores which will be able to enter the urban market.

This urban move would seem somewhat risky; can a model based on large stores and inventories really be shrunk? But the high traffic provided by these areas along with an increase in demand for value products, should ensure success. Furthermore, these developments lend credence to the notion that urban investments are at present some of the best and most secure. The net lease market has observed continued success in regard to its urban properties and expects the trend to continue.

Franchisee or Franchisor?

Currently there are around 1 million franchise outlets in the United States and over 40,000 international ones operated by U.S. based franchisors. Ownership and operation of these outlets can differ greatly depending upon their parent corporation. For instance Burger King franchises around 90% of their restaurants, McDonalds 80%, Wendy’s 79%, and Arby’s 69%. Conversely, large investor groups, such as Bain Capital, can also decide whether to license out the business model and make money off royalties or operate the franchises themselves, earning revenue directly. This decision is highly dependent upon the market in question and impacts future management of the property.

Typically, franchisors have three main sources of income, (1) retail sales at Company-operated restaurants; (2) franchise revenues, consisting of royalties; and (3) property income from restaurants that the parent company leases or subleases to franchisees. If a company were to engage in the first, it would necessarily negate the latter two and vice versa. In order for the first option to make sense, the specific franchise would need to operate with larger margins. For example, Bain Capital, which owns a 93% controlling economic interest in Dominos Pizza, chooses to sell the franchise rights of most of their stores (including U.S. based ones) but operates outlets based in Japan. This is because pizza delivery is considered a luxury item there, with people willing to pay up to $43.00 dollars for a single delivered pizza. Thus in Japan, it is more economical to operate rather than sell the franchise rights. Conversely, in the U.S., where pizza delivery is assuredly not a luxury item, it makes more sense to sell the franchises as margins are lower.

Should a parent company choose to own and operate a store, it can receive benefits related to its applicable real estate. A location operated by a parent company with investment grade credit, will instantly increase in value. This is because the locations returns are no longer guaranteed by an individual franchisee who has no credit rating but by a company which does. Furthermore, that company can still pull money out of the property through a sale-leaseback. This allows the company to take advantage of the properties increase in value and pull capital out for other uses. These factors are highly evident in net lease properties, where credit ratings are of high importance and sale leasebacks have always been very popular. A property which is corporate owned and guaranteed will typically fetch a much higher price than an individual franchisee due to the flight to quality in the current market.

The decision between owning/operating and franchising a property greatly impacts how it is valued. It also impacts the level of commitment and funds a franchisor dedicates to it. The applicable margins of the specific locale and the opportunity for greater profitability will then be the decisive factor.