Walgreens Goes Urban With Duane Reade

Walgreens recently closed the purchase of Duane Reade, a deal which included “all 258 Duane Reade stores in the New York City metropolitan area, as well as Duane Reade’s corporate office at 440 Ninth Ave. and two distribution centers”. The transaction was all-cash and involved the absorption of $457 million in debt. This bolsters Walgreens already impressive presence in the drugstore/pharmacy market, adding a prominent urban chain and presenting new opportunities for net lease investors.

Duane Reed, which had struggled under debt and in July 2009 was downgraded to CCC+ by S&P, will certainly become more appealing now that it’s helmed by A+ rated Walgreens. In addition Walgreens has “agreed to repay or redeem Duane Reade’s outstanding debt related to the local chain’s July 2003 credit agreement, its 9.75% senior subordinated notes due 2011, its 11.75% senior secured notes due 2015, and its senior convertible notes due 2022.” The looming question is whether Walgreens will back Duane Reade leases or if they will be allowed to stand alone. If Walgreens does agree to back the leases, a high investment grade product would be added to the net lease market, if not, the asset will at lease become more attractive under the Walgreens flag.

This transaction also represents a great expansion into one the largest urban areas in the country by Walgreens. Duane Reade is centered in the New York metropolitan area and this purchase shows Walgreen’s desire to enter the urban market with force. This situation deserves close monitoring by those who are considering a net lease asset or have interest in investing in the surging urban market.

US Apartment Uptick = Net Lease Impact

It has been recently reported that the US apartment market may have reached bottom and be poised for a rebound. Apartment vacancy rates have stopped rising and rents even showed a modest increase in the first quarter. As life is pumped back into this market, 1031 exchanges could subsequently rise. Apartment investors heavily utilized 1031 exchanges to move from active to passive assets (such as net leases) in the past. Will this trend repeat?

To gain insight, we have solicited the help of James Brennan Esq., LL.M., Managing Director and Corporate Counsel of Exchange Solutions Group, one of the foremost experts of 1031 exchanges.

1. With the possible return to health of the U.S. apartment market, do you expect to see increased 1031 tax exchange action?

The Baby Boom generation flocked to real estate as an investment class, particularly multifamily. With Baby Boom private investors aging and looking to make life decisions regarding retirement, relocation, and estate planning, and all of those activities are distinguishable from the active process of “adding value” to apartment complexes through sweat equity and property management. Many of those B and C investors are looking to get out of active management. After living through this cycle, they want out more now than ever.

2. What makes apartment owners keen to move from an active to passive asset?

Passive triple net leases are net insurance, net utilities, and net taxes to the tenant. Apartment owners that have built a net worth over $5 million are looking to create annuity-like income for their heirs who often are not in the real estate business. These family patriarchs and matriarchs are not looking to burden their heirs who often are busy professionals in metropolitan areas with decisions regarding leasing up property or fixing the roof. Triple net leases provide credit-rated tenants with predictable cashflow.

3. How popular are net leases for those exchanging out of apartments?

Net leases are not only used by multifamily baby-boomers but also multifamily “financial engineers”. While multifamily financing is often favorable from agencies like Fannie and Freddie many borrowers are in troubled financial shape with distressed assets. These assets often don’t pass muster to be financed or refinanced with agency debt. These investors can 1031 exchange either with low equity or after conducting a deed-in-lieu 1031 into a net lease. Once in the net lease asset, the equity can be unlocked fairly easily through either credit-tenant-lease paydown readvance or through a standard refinance. These strategies allow multifamily borrowers to get an asset banks trust more with a credit rating.

4. What is the psychographic profile of a typical investor who executes this strategy?

Apartment developers are often drivers or family stewards. These decision-makers have built wealth from the ground up often not in a traditional white-collar methodology. These hard-driving decision-makers have provided for their family, and also probably have setup life insurance trusts to allow for estate planning liquidity. Triple net leases go well with this concept of transitioning wealth to the next generation without many opportunities for losing value by the heirs. The family stewards have built wealth and are now simply trying to preserve it.

5. Are there any aspects of this strategy conducive to estate planning techniques?

In an effort to defer capital gains while family stewards are still living the patriarch or matriarch often engages in a like-kind exchange to transition between apartment assets and net lease assets. In a like-kind exchange you can trade into multiple replacement properties. Therefore, if you have three children and you sold your apartment complex for $15 million, you can buy three $5 million dollar net lease assets that produce income that can be divided up amongst the heirs. This avoids management by the one heir that may be more real estate savvy.

Equally as important, the credit-rated aspect of net leases allows trust officers and advisors to sleep at night knowing that they made defendable decisions on behalf of the trust. Therefore, if a real estate trust officer is transitioning from apartment assets, net lease income streams are fiduciary friendly.

An End to Our Long Winter?

Recently Diane Swonk, Economist and Federal Reserve Board advisor, highlighted seven factors which indicate our recession is coming to an end. She is quick to note that the gains are not definite; stating “whether those gains can be sustained long enough to bring down unemployment remains an unknown” and characterized any potential recovery as “rocky”. Nevertheless, her points can be taken as a glimmer of hope.

Here are the points as she outlined them:

1. The pace of layoffs is abating, instead of accelerating.
2. Production is on the rise, albeit from anemic levels.
3. Home sales are surprisingly on the upside.
4. Profits are surprisingly on the upside.
5. Financial markets are rallying, to some extent.
6. Core consumer spending, driven by pent-up demand, appears to be regaining some momentum.
7. Factory orders could be picking up from rock-bottom levels.
   

A common thread in many of these is the sign of some gain from heavily recessed conditions. None of these marks a return to levels we would hope to consider “normal” but they do represent small, perhaps significant, changes. Taken together they lend credence to the notion that the bottom of the crisis has been felt and we are now on the road to recovery, albeit “rocky” recovery.

Ms. Swonk also mentions that “Consumers are going to have to remain more defensive than offensive in 2010”. But what about investors? If these signs really point to recovery, this could be one of the last chances to invest in a recessed market. Net lease assets have fared better than most commercial real estate and continue to be a safe bet for the future. Financing still remains tough but for those with the resources, getting a net lease asset before the market enters full recovery could be a good move.

Net Lease Cap Rates vs. T Bills

Cap rates are an important economic indicator for the net lease market as they effectively reveal supply and demand of NNN investment property and the return investors expect for their NNN investments. Furthermore, when compared with Treasury Bills, NNN investment property and the Net leases behind them offer an interesting picture of the ebb and flow of credit and risk and a window into the behavior of lenders and investors alike.

If we think of Net Leases as a bond like asset backed by real estate and the credit strength of the tenant, we see that cap rates and T-bills move in opposite directions in response to the rise and fall of interest rates. The returns offered by T-Bills rise when interest rates fall. For NNN properties, a fall in interest rates has an opposite effect driving cap rates lower as the drop in the cost of debt makes a lower return tolerable to NNN investors. Said another way, T-bill rates typically rise during periods of business expansion and fall during recessions. The economic engine that drives up the return for T-bills typically drives down the return offered by Net lease investments. This effect is compounded as the competition amongst investors pursuing Net lease properties drives cap rates down even further.

So where are we today? It is still too early to tell but preliminary data for 2010 suggests that the steady rise in cap rates that began in 2008/2009 may be leveling off. Lack of quality product, low interest rates and a very modest thaw of the frozen debt market may be responsible. Warren Buffet and others have pointed out that it is a fool’s game to try and time the market but the day of bargains in Net lease investments may be coming to an end.

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.