Drug Store Wars

Recent developments concerning Walgreens and CVS point to changes in their stores and company interactions. These range from alterations in store layout and product offerings to new rules concerning prescriptions. Both of these tenants are huge players in the net lease market and these shifts could change the way investors view them.

CVS to Expand Grocery Aisles

CVS plans to expand grocery aisles in 3,000 of their stores during 2010. They will be doubled in size, giving the company more exposure to the trillion dollar U.S. food market. Many see this as continuation of “channel blurring”, a trend which has been embraced by many retailers. As reported by the Patriot Ledger “Just as supermarkets have expanded pharmacy and health and beauty sections in the past decade, drugstores are retaliating by putting food products in the forefront.” Cleary CVS is jumping in head first by modifying 43% of their 7,000 nationwide stores.

Walgreens to Sell Beer and Wine Again

Walgreens is breaking a nearly 15 year self-imposed ban on the sale of alcohol in their stores by reintroducing beer and wine. So far 3,100 (41.3%) of their stores have already been stocked, with plans to increase that number to 5,000 by years end. Previously the sale of alcohol and other spirits made up 10% of Walgreens total sales, indicating a likely increase in sales this year. Other drugstores such as CVS and Rite Aid have continually sold alcohol. It is available in 4,300 (61.4%) of CVS stores and 28 of the 31 states Rite Aid operates.

CVS to Exclude Walgreens from Retail Pharmacy Network

CVS Caremark has stated it will end their retail pharmacy partnership with Walgreens in roughly 30 days. This occurred in response to Walgreens announcement that it will no longer participate in new CVS managed prescription drug plans. Thus, the pharmacy networks of the two will become mutually exclusive forcing customers to one or the other. This certainly heightens the competition for customers between the two and could increase marketing to that effect.

Looking at the situation from an investor’s standpoint, the first two changes are certainly positive. CVS expanding their food section is in line with a nascent trend of frugality and “back to basics” purchase behavior. Walgreens on the other hand is opening itself up to the conclusively popular trade in alcohol which should only benefit their store revenues. The only trend which could be perceived as worrisome is the segregation of prescription customers. Forcing an exclusive choice could lead to higher costs to maintain and attract new customers. However, such fears maybe overblown. A little competition never hurt anyone.

ICSC RECon 2010

Net Lease Insider asked Patrick Nutt to contribute his analysis of the 2010 ICSC convention.

It is as follows:

In the weeks and months leading up to this years ICSC convention in Las Vegas, everyone I spoke with had uncertainty about the overall turnout and value in attending the conference this year. Well, as I sit in my office fresh off a 72 hour session of networking, deal making, and walking (lots and lots of walking), I can emphatically say that once again it was a great event and well worth attending. While we can all work effectively through the use of emails and phone calls, the opportunity to sit down face to face with clients and discuss existing business and future plans is always time well spent. I am still revisiting all the conversations I had and observations I made, but here’s a glimpse of what I took away from the show.

Attendance:

I heard various numbers mentioned from a variety of sources, but I would say that attendance was about even with last year, however activity was up. It seemed as though most attendees this year had pretty busy schedules and were discussing real activity that will occur over the next 12 months, rather than casually discussing hopes and plans like the 2009 version of RECon.

Prettiest girl at prom award goes to: Dollar General.

All aspects of the net lease world were feverishly talking about Dollar General and their aggressive expansion to include 600 new stores a year. We’ve seen merchant developers that formerly focused on power center and grocery anchored locations now shifting their resources toward building 20-60 new dollar general stores in the coming months. REITs and private funds alike are looking to this retailer to fill their need to place capital. This is purely a numbers game for all parties, as Dollar General needs to open these stores to keep Wall Street happy, merchant developers need volume to create efficiencies to make this a profitable program, and the institutions need this same volume and a pretty yield to make sense of acquiring assets generally priced in the $850k to $1.5M range. This could be a winning combination for all, but we’ll be keeping a watchful eye on this program to see if everyone can execute on these plans.

Biggest Question: What do I do with all this money?

That was basically the continuing theme from the institutional groups. With the rebound in the REIT sector, they are all flush with capital and need to put that money to work. They are paying their investors a return from the day they receive it, so money not spent is worse than accepting a slightly lower cap rate. With the lack of product on the market, acquisitions are in short supply and has everyone searching for quality assets. With the dead pipeline from the past few years, very little new development is coming out of the ground, forcing buyers to chase existing properties, but owners are repeating the same question…..if I sell today, what do I then do with the money??

Retailer Activity:

If you are a net lease player, the next 12-24 months should be exciting as the typical single tenant retailers were discussing new stores, relocating old locations, reasonable growth in strong markets, etc. For those in the shopping center, power center, or regional mall world, recovery is still a long ways off. The big box tenants are still waiting patiently for more signs of recovery in the global economy before moving forward with new locations. 2010 and 2011 will see the smaller retailers continue their slow growth plans, while big boxes will begin to move forward in 2012-2013…..that is if the economy and job markets continue to stabilize and improve.

Phrase least heard: “Distressed Properties”

What seemed like the mantra of the 2009 RECon was almost never brought up this year. Much of the capital raised over the past two years has yet to be deployed, and would-be vultures have accepted the reality that lenders and servicers simply don’t have the need or ability to flood the market with distressed assets. They have proven that they would prefer to work with existing borrowers and renegotiate the debt terms or extend maturities rather than take a greater loss by selling into a market filled with bottom feeders.

Overall, it was a good show with great activity from all participants. While we are still a long way from being out of the commercial real estate mess of the past several years, people in every aspect of the industry have learned a new reality for deal flow and real estate fundamentals. The industry is very different today than in previous years, the reckless have wrecked themselves, while the experienced and diligent have found a way to stay alive and do another deal.

Opportunities on the Cutting Floor

A Landlords primary responsibility is to ensure the presence of a paying tenant. Unfortunately for many “big box” owners, the recession has left plenty of space empty; with slim chances of new tenants filling it. There is simply little interest in the cavernous lots so many feared would dominate the landscape. Retailers are demanding tighter, more economic space and landlords are responding by cutting up their “big boxes”, meeting the needs of retailers and creating new opportunities for net lease investors.

It is no secret that retail has suffered heavily since the recession. In its wake, a movement has emerged known as “right-sizing” which places a focus on frugality and sustainability. This trend has traditionally been popular with smaller retailers such as Dollar General but is now even catching on with retail giants such as Wal-Mart and Target. Both are testing smaller floor plans as they move into more urban locations and cater to scaled back consumer demands. Such developments slim the chances that vacant big-box space will fill quickly and has forced landlords to “de-box”.

Net lease investors should be intrigued by this trend because many of the tenants positioned to make use of these smaller lots are usually triple net leased. Dollar stores, such as Dollar General, Family Dollar and Dollar Tree, all have plans for expansion this year and are prime candidates to occupy the de-boxed space. Other possibilities include auto-part stores such as Advance Auto and AutoZone and certain restaurant tenants. Though not the ideal of full market recovery, this development highlights market movement and movement is a good thing.

Are Cap Rates Going Down?

A recent article by M.P. McQueen in the Wall Street Journal stated that cap rates for investment grade triple net lease properties were falling. Specifically it said “in recent months, cap rates have been falling because property prices nationally are rebounding. More investors are going after fewer high-quality properties, driving prices up.” In order to gain a wider perspective on this topic, we asked two industry experts, who have capital available and are active in the market, their opinions on cap rate trends today and by years end.

Here are their responses:

Jon Adamo, National Retail Properties.

I would agree that over the last few months we’ve seen a decrease in cap rates of higher quality net lease investments in the range of 25 to 50bps from pricing we experienced in 2009. There’s definitely a supply and demand issue at the root of the adjustment along with an improvement in the ability of buyers to get the better tenants/deals financed. The scarcity of new deals hitting the market will continue to keep cap rates low for the remainder of the year and may cause them to go even a little lower but not significantly. The cost of financing is still very much a factor for many deals and although banks are doing very safe deals at very safe rates and terms they have certainly not opened their doors all the way.

If you look out past the next 6 months and into the next year I think caps will be moving up with rising interest rates. I also see more product reaching the market as developers begin to reemerge and M&A activity picks up thus producing some sale-leaseback opportunities for buyers that might look to dispose of some assets. For now it seems there’s a glut of capital for good Walgreens and McDonald’s-type NNN investments and not enough to go around putting stress on cap rates but higher rates and lower ltv’s of the new financing “norm” will cause the cap rates to rise eventually.

George Rerat, Senior Vice President of Acquisitions, AEI Fund Management, Inc.

We’ve seen cap rates for high quality NNN properties decrease from around 9.5% to 9.0% today. This drop is a reflection of the dwindling supply of high quality NNN properties on the market. Construction has been at a relative standstill and as such the pool of these assets has been shrinking, forcing cap rates down. By years end we could possibly see cap rates drop by another 50 basis points. Furthermore, it may take a while for construction to pick up again, prolonging the supply imbalance for the next 1-2 years.

So the question becomes whether or not the window is still open, as supply continues to constrict and the laws of economics take hold.

Springtime for Retail, Sale Leasebacks, and Urban Investments

As spring unfolds, key areas of the net lease market such as retail, sale leasebacks and urban investments seem set to grow. Numbers and analysis from the first quarter of 2010 point to better days and more opportunities ahead.

Retail

As of March 2010 consumer spending has increased over the past five months and retail sales have risen the past four. Retail sales in the first quarter 2010 are up 1.9% over the previous quarter and up 5% compared to the same period last year. Retail transaction volume totaled $3.1 billion for the 1Q 2010, which is a steady improvement from $2.2 billion in the same period last year. Furthermore, according to a major commercial real estate magazine “investors are showing strong interest in well-stabilized retail properties that generate consistent cash flows”. This description fits perfectly with net lease investments, which are defined by their stability.

Sale Leasebacks

It has been estimated that there is at least $1 billion in corporate owned essential real estate and according to RW Baird “strong corporate demand for sale-leaseback transactions”. If only a fraction of this $1 trillion were to enter the market, it would be a huge boon for net leases. Sale-leasebacks, which are almost always structured as net leases, offer corporations a chance to pull vital equity out of their real estate and enhance current operations. The real estate is sold and a long term lease is signed which leases back the property. Sale leasebacks have already provided the basis for many net lease transactions in the last two years and that trend looks to continue to pick up steam.

Urban Investments

There has been a lot of talk about the upward trend in urban investments. Walgreens purchased Duane Reade and their 258 New York metro area locations for $1 billion and those leases have been recently valued at $74 million. The German group, GLL Real Estate Partners also entered the urban market by purchasing 14,000 sq. ft. of New York retail condominiums from Hines. The urban market is one the most attractive today because it ensures a properties close proximity to large populations. As a result, net lease urban properties have increasingly been in demand.

Is Retail Development Picking Up?

In a retail climate often described as a veritable desert for new developments, there have been recent signs of life. David Sobelman, Executive Vice President of Calkain Companies, has observed that in high credit tenants, there has been a relatively unnoticed trend in developments.

Below he answers five questions relating to this trend:

1. What, if any, developments are you seeing in the net lease or retail markets?

High credit tenants, those with investment grade credit ratings, seem to be the only tenants currently seeking expansion opportunities. These include Walgreens, CVS, TD Bank, Chase Bank, Blue Cross Blue Shield.

2. Do you see any trends developing which may indicate our future?

It seems that there is more “chatter” about looking for new sites; either ground up development or retrofitting existing locations for new tenancy.

3. Have you seen any tenant development lately? If so, how much and concerning which tenants or sectors?

Short answer, yes. Walgreens is active, as is CVS. Drug stores, c-stores, some banks are taking over vacant bank sites through mergers mostly though.

4. Why do you think there is a preference to develop new properties when vacancies are very high?

Cheap land. Lower construction costs, developers being able to negotiate better contracts with contractors to build sites and increase their overall returns.

5. Are these developments related to certain areas, such as the urban market?

There is a definite trend towards proven markets, urban real estate falls into that category. Less speculative areas are sought out more than “in the path of growth” areas that were popular 3-5 years ago.

$55 Million Net Lease Leaves Harbor

On March 17th CNL Lifestyle Properties, an Orlando based REIT, acquired four California triple net lease marinas (the Anacapa Isle Marina is pictured above) through sale-leaseback deals worth a total of $55 million. The marinas are strategically located next to California’s three largest cities of Los Angeles, San Francisco and San Jose and add 1,984 boat slips to CNL Lifestyle properties marina portfolio (19 in all). Almar Management, the current operator, will continue to run the marinas and according to Almar’s CEO Randy Short, the deal will enable them to “focus on property enhancements that improve the experience for our boaters and their families”. These deals represent an interesting upsurge in non-traditional net lease activity.

CNL Lifestyle Properties focuses on “lifestyle” assets, such as golf courses, ski resorts, marinas and various other attractions. Their portfolio contains properties which are almost always structured as triple net leases and provides an intriguing investment angle. According to Byron Carlock, President of CNL Lifestyle Properties, these assets are “supply constrained”, ensuring a low threat of new entrants and stable demand. He also noted that though spending had decreased during the recession, attendance actually remained consistent, demonstrating stability in demand. Furthermore, CNL did not encounter a bankruptcy or default in any of its assets.

This year, CNL plans to invest $300-400 million in new lifestyle assets. Their conservative financial strategy has created a portfolio that is 28% leveraged by debt, though their long term target is 50%. Mr. Carlock noted their properties receive a high level of return due to their portfolio being acquired at around an 11% cap rate. He also interprets an increased interest in the market as more private equity firms look to enter the lifestyle area.

Though for many, the term “net lease” conjures up images of mundane grocery stores, Walgreens, and McDonalds, there is actually a diverse array of triple net properties in existence. This is no better highlighted than by the “lifestyle” assets which CNL Lifestyle Properties specializes in. Though the recession may have hit people hard, many still find ways to enjoy themselves and take part in their hobbies. As Mr. Carlock observed, “pursuing ones passions does not involve extravagance”.

This article was contributed to by Mr. Byron Carlock, Jr. president and CEO of CNL Lifestyle Properties,Inc., an unlisted real estate investment trust that owns a portfolio of 119 lifestyle properties in the United States and Canada. Headquartered in Orlando, Florida, CNL Lifestyle Properties specializes in the acquisition of ski and mountain lifestyle, attraction, golf and other lifestyle assets.