MATTHEWSA COMMERCIAL REAL ESTATE PUBLICATION AT THE INTERSECTION OF INNOVATION AND INFORMATION

The Drug Store industry remains one the most competitive segments in the net leased space. Average cap rates remain low and total drug store transactions remain high. Both private clients and professional investors are taking advantage of the appreciation in the value of their assets while cap rates remain compressed.

The drug store sector has been dominated by acquisitions and mergers as of late which has in turn affected the net leased market. Walgreens $17 billion proposed acquisition of Rite Aid, if approved, would have a monumental impact on the net leased drug store market. Walgreens and Rite Aid’s significant overlap in some US markets means that a rumored 500 to 3,000 Walgreens stores could be forced to close due to Federal Trade Commission regulatory requirements. The FTC’s approval or denial of

the Walgreens – Rite Aid merger is expected by the end of 2016 and if approved, will significantly impact the drug store sector.

When you combine some uncertainty with the fact that it’s nearly impossible for a drug store to ever be worth more money than it is today, we have seen an increase in available inventory. In fact, there are over 500 drug stores on the market today, which is one of the main reasons we have seen cap rates begin to stabilize. Rents remain high in the drug store market as the tenants compete for the strongest signalized corner. Drug store rents can be double what the normal market would suggest, which is why most drug stores often times ask for significant rent reductions to extend out a lease.

Despite there being over 500 total drug stores built since the beginning of 2015, nearly 70% of those are relocation stores. The majority of new construction CVS, Walgreens and Rite Aids are the relocation of existing stores that didn’t fit their desired prototype; free standing, strong corner, and drive-thru locations. The real estate plays a big factor for CVS and Walgreens in particular as they compete over hard corner locations with premier visibility and high traffic counts. CVS, Walgreens, and Rite Aid rarely close down prototypical store formats that are well performing stores unless they have a superior relocation opportunity. CVS is the only drug store actively expanding their national presence – currently building new locations in the Mountain Region and the Pacific Northwest.

NEW STORE OPENINGS

DRUG STORESCREDIT RATINGS

CVS: BBB+RITE AID: B

WALGREENS: BBB

0 50 100 150 200 250 300

2011

2012

2013

2014

2015

NEW STORE OPENINGS

Walgreens is the top traded drug store over the last three years with 476 transactions, CVS is second at 388 transactions, and Rite Aid at 209 transactions. In all, there have been over 1,064 single tenant (non-portfolio transactions) over the last three years, meaning about a drug store a day trades on average. Walgreens and CVS have always been the gold standard for STNL transactions because of their strong credit and bond-like leases backed by quality real estate.

Since the announcement of the Walgreens – Rite Aid merger, total transactions for these two tenants have dropped by almost 20 percent as their uncertainty of potential store closures. There has been particular hesitation from the market of Walgreens and Rite Aids that are in close proximity to one another. In addition, many investors recognize that because their drug store has no rent increases, their property will likely never be worth more than it is today, leading to a substantial amount of inventory on the market.

TOTAL TRANSACTIONS

CVSRITEAIDWALGREENS

467

388

209

# OF TOTAL TRANSACTIONSIN THE LAST 3 YRS

Walgreens demands premier hard corner locations, which explains why they have the highest average rent of the three main drug stores at slightly above $350,000. CVS rents, on average, are only slightly lower than Walgreens, and Rite Aid remains the lowest, often because of the leases signed years ago when rents were drastically lower. The bidding war for premier locations makes drug store rents nearly 2-3 times what the actual market rents would suggest. In the event that something happens and the tenant vacates for one reason or another, including a potential merger, it can be nearly impossible to replicate the income an owner is

receiving. This is no surprise to the tenant as well, which they often leverage into slashing rents for early extensions or to pick up an option.CVS develops on a fee-basis and does sale-leaseback portfolios, which is key to keeping rent low for stores while Walgreens have often relied on developers for new store development. Rite Aid pays some of the highest rents for new construction deals, which often includes a rent increase in the base term, but average rent remains low due to older construction deals in tertiary markets on the East Coast.

AVERAGE RENTS

$100K $150K $200K $250K $300K $350K $400K $450K

AVERAGE RENTS

Drug stores are no different than the rest of the net leased investments, as the guaranteed term remaining on the lease wears down, cap rates rise. In analyzing the data of recent drug store transactions, we see a gradual, but steady, drop off from year 25 to year 10. However, the drop off accelerates at the 10-year point and continues to drop each year after buyers are no longer able to achieve attractive, long-term financing terms. On average, across all drug stores, there is about 200 bps of spread from a brand new 25-year drug store lease to a 5-year deal. With no rental increases in the base term, this can lead to the property being valued 30-40 percent lower over the course of this time. With average drug store prices in the $5M to $10M range, an investor can often lose several million dollars of equity over time.

CVS, Walgreens and Rite Aid are each very selective of the leases they extend early or beyond the 5-year renewal options. Typically, they only extend leases early on sites that are above-average performers. For the typical private client drug store owner, their ability to add value to short-term drug store is minimal. So for a private client, the ideal time to maximize value is to dispose of the asset before the lease term gets to 10 years.

CAP RATE CORRELATION

CVSRITEAIDWALGREENS

There are more drug stores on the market than we have ever seen as owners attempt to take advantage of unprecedented high property values. As of August 1st, there were 533 single-tenant, non-portfolio, total drug stores listings. This has led to cap rates leveling off, and in the case of Walgreens, actually are trading slightly higher than this time last year. Over the last five years, we have seen cap rates compress nearly 150 basis points for new construction and average cap rates.

With the uncertainty surrounding the merger between Walgreens and Rite Aid, CVS has propelled itself as the most desirable net leased drug store and cap rates are still decreasing. New construction deals remain highly desirable for drug stores with cap rates hovering in the high 4% to low 5% range. While Rite Aid doesn’t have the same credit as their peers, the rent increase in the base term and options help keep cap rates low for their new deals.

AVERAGE CAP RATES

6%

8%

7%

9%

2011 2012 2013 2014 2015 20164%

5%

AVERAGE CAP RATES

* BARS REPRESENT AVG CAP RATES* LINES REPRESENTS AVG CAP RATES FOR NEW CONSTRUCTION

4% 6% 8% 10% 12%0

5

10

15

20

25

CAP RATE CORRELATION

LE

AS

E T

ER

MS

(Y

RS

)

CAP RATE

Data source: Costar & Real Capi ta l Analyt ics*Al l 2016 data is year to date

Despite any long-term concerns of the drug store industry, the immediate outlook for the net lease drug store sector remains stable. Because of the strong corporate backing and long-term leases, drug stores will continue to trade at aggressive cap rates. The Walgreens and Rite Aid merger, if approved, is something to be wary of as stores will likely be sold off or shut down, which would cause a hiccup to the drug store market.

Each of the drug store chains has experienced substantial development of new stores in the late 1990s and early 2000s, as the initial leases come up for renewal, we should expect to continue to see rent reductions and closures over under-performing sites. While drug stores are still considered the gold standard in the net lease space, the perception is beginning to

change. Many investors understand the importance of rent increases to preserve their equity and recognize that the tenant often has the leverage during the option period, which can put landlords in a difficult position.

It is no secret that the US is an aging population. The aging baby boomers will undoubtedly add to the demand for healthcare in a substantial way. Although this demographic shift may have negative ramifications for much of the economy, companies providing healthcare services stand to reap the rewards of an older country in need of increased medical care. CVS, Walgreens, and Rite Aid are all strategically positioning themselves to new healthcare demands by acquiring key competitors. CVS ban on tobacco products and their acquisition of Target’s pharmacy is the perfect

example of the drug store industry evolution from a retail pharmacy into an all-encompassing health service provider.

In order for drug stores to stay relevant, they need to continue to evolve. Nearly two-thirds of all sales from drug stores are prescription based and with new ways to obtain prescription drugs today, there is cause for concern. When you combine this with front end items getting eaten up by dollar stores, grocery stores, and e-commerce platforms, drug stores need to adapt. The company that can best adapt to the evolution of the drug store industry will be in the best position moving forward.

FUTURE OUTLOOK

FOR MORE INFORMATION REGARDING DRUG STORES PLEASE CONTACT:

BILL PEDERSENbi l l .pedersen@matthews.com949.432.4501

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Matthews REIS Disclaimer 2016

This publication has been produced by Matthews Retail Group, Inc. solely for information purposes and the information contained has been obtained from public sources believed to be reliable. While we do not doubt their accuracy, we have not verified such information. No guarantee, warranty or representation, expressed or implied, is made as to the accuracy or completeness of any of the information contained and Matthews REISTM shall not be liable to any reader or third party in any way. This publication is not intended to be a complete description of the markets or developments to which it refers. All rights to the material are reserved and cannot be reproduced without prior written consent of Matthews REISTM.