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The Rite Real Estate Play?

Drug store operator Rite Aid’s $3.4 billion proposed acquisition of 337 Brooks and 1,521 Eckerd stores is a bold bid to catch industry leaders CVS and Walgreen’s—and that could be good news for net lease investors.

The deal is critical to Rite Aid's continued recovery from accounting fraud and other missteps under former CEO Martin Glass. For investors, the expansion could mean more buying opportunities if Rite Aid ups its sale/leaseback pool. Drug stores are popular targets for 1031 exchangers and other small investors.

Walgreens and CVS currently account for 90 percent of available net lease supply in the category and fetch prices of $392.04 and $352.44 per square foot, respectively, according to net lease real estate investment firm Boulder Group. Rite Aid, despite a stock of more than 3,000 U.S. stores, has very few sites up for sale. It is among a group of several chains accounting for just 2.6 percent of current available supply. Eckerd, meanwhile, represents about 7.8 percent of the supply and gets an average $320.63 per square foot.

Boulder Group president Randy Blankstein thinks the combination of Rite Aid and Eckerd will help both brands and make those assets more palatable to net lease investors.

“I think that many people were uncomfortable with Eckerd because it was controlled by a Canadian entity,” Blankstein says. “Rite Aid is a publicly-traded company, with a publicly-traded debt, and it is a much better-known chain, so people will feel more comfortable buying them because some of the uncertainty over the Eckerd brand has been resolved.”

Joseph French, senior vice president of institutional retail sales with Sperry Van Ness, believes that investors have gone overboard in their love for Walgreens—which fetches 6.3 percent cap rates in contrast with 6.46 percent for CVS, 6.91 percent for Eckerds and between 7.5 percent and 7.75 percent for Rite Aid. French thinks the new deal will drive more investors to consider Rite Aid locations.

“Walgreens is still the darling,” French says. "For logic that is beyond me, they sell at incredibly low cap rates." The problem, he says, is that Walgreens demands leases up to 40 years, which gives investors less flexibility in the long run.

The deal will also expand Rite Aid’s presence in markets where investment interest in drug stores has been the strongest. According to the Boulder Group numbers, 67 percent of the 543 currently available properties are located in 10 states: Texas, Florida, California, Georgia, Illinois, Pennsylvania, Ohio, Indiana, North Carolina and Alabama.

“It’s going to be interesting to see how this all plays out, but I think that it is a good move for Rite Aid to go into states they were not in before and it’s going to be a lot faster than doing one store at a time,” French says.

The acquisition will bring Rite Aid’s portfolio to 5,000 stores in 51 states, with the Eckerd chain providing the company with exposure on the West Coast and in the South, and the Brooks division covering the New England market. Rite Aid will invest approximately $500 million to upgrade the newly acquired stores, with plans to open another 800 to 1,000 locations in the next five years.

But Morningstar analyst Mitchell P. Corwin says that he's concerned about Rite Aid's taking on of $2.2 billion in debt to complete the transaction. He cites the low profit margin of the prescription drug-selling business and the saturation of the drug store market as reasons for his target price on Rite Aid stock being $5 per share. It currently trades at $4.36 per share.

“While the [deal] will give Rite Aid important economies of scale in a low-margin industry, it will also create a highly leveraged firm with under-performing stores that faces tremendous competitive threats over the long run,” Corwin writes. “The number of stores will compare favorably to Walgreens and CVS; the economies of those stores, collectively, will not.”

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