Appraising Leased Fee Interest With Major Drugstore Tenant.

[Maineiac]

I’m appraising the leased fee interest in a property leased by a major drugstore. Applying direct capitalization and planning to use actual lease income as current market rent in the PGI. (Haven’t had any luck finding rent comp data for this property type.) The 20-year lease expires in 3 ½ years with 5 five-year renewal periods. Regarding a vacancy & collection loss factor, one opinion expressed was why would you (apply a loss factor in this case)? Any thoughts on the vacancy & collection loss factor? Would you expect to find a reserves for replacement allowance in the 3%-5%. Management fee in 3%-5% range?

Any advice or input on this assignment would be appreciated. Thanks...

 

[Michael S]

Sounds like this is a typical single tenant net leased property. Investors look at these more like a corporate bond than just real estate. Walgreens, CVS, or Rite Aid they're all going to trade in a pretty narrow cap rate range that depends on the remaining lease term and the credit of the tenant. Management fees and reserves for replacement aren't used by brokers or investors in these properties. Maybe if it's a NN lease where the landlord is responsible for roof replacement, but in most cases the tenant is responsible for virtually everything. Typically we never apply any vacancy or collection loss for single tenant net lease properties where there's at least 10 years of lease term remaining. Less than that and you may be justified in including a vacancy factor, if you don't think the tenant will renew (i.e. low retail sales, declining area, new stores with better locations in the vicinity, etc.)

Here's a good resource for these types of properties - http://www.bouldergroup.com/research.html

3 1/2 years remaining on the lease will definitely drive a higher cap rate but I've been surprised at how low of a cap rate some of these properties have sold at that have short remaining lease terms. If a new drug store with a 25-year lease went on the market today it would probably sell at a sub 6% cap rate (CVS or Walgreens, Rite Aid quite a bit higher). The same property with less than five years on the lease term might still sell at a 7-8% cap rate.

 

[Mark Field]

I’m appraising the leased fee interest in a property leased by a major drugstore. Applying direct capitalization and planning to use actual lease income as current market rent in the PGI. (Haven’t had any luck finding rent comp data for this property type.) The 20-year lease expires in 3 ½ years with 5 five-year renewal periods. Regarding a vacancy & collection loss factor, one opinion expressed was why would you (apply a loss factor in this case)? Any thoughts on the vacancy & collection loss factor? Would you expect to find a reserves for replacement allowance in the 3%-5%. Management fee in 3%-5% range?

Any advice or input on this assignment would be appreciated. Thanks...

With a credit tenant, you typically would not apply a vacancy & collection loss factor. This potential risk should be incorporated into the selected cap rate. Most brokers, investors, and appraisers do not apply a management fee or replacement reserves. They are focused on annual cash flow from the lease payments. With only 3.5 years remaining on the initial lease period, you should conduct some research of the tenant's credit rating to judge how strong the company is as a whole. I would recommend conducting some local market research also to make a determination of competing drugstore proximity, as well as same brand drugstores. This might give you some insight regarding the likelihood of the tenant exercising one or more of their renewal options. You might consider performing a Discounted Cash Flow Analysis, as a potential investor would find this of value.

 

[Howard Klahr]

Typically we never apply any vacancy or collection loss for single tenant net lease properties where there's at least 10 years of lease term remaining.

With a credit tenant, you typically would not apply a vacancy & collection loss factor.

And how many of these are you aware of? These are just pharmacies, let alone other major retail operations.

• A. L. Price – Metro Detroit; part of Perry Drug Stores
• Arbor Drugs
• Big "B" Drugs
• Cunningham Drug
• Dart Drug – converted to Fantle's
• Disco Drug and Discount Centers
• Drug Emporium
• Drug Fair
• Eckerd Corporation
• Fantle's
• Farmacias El Amal – San Juan, Puerto Rico
• G. O. Guy
• Giant T – owned by Thrifty PayLess
• Gray Drug
• Haag Drugs
• Happy Harry's
• Hook's Drug Stores
• K&B (also known as Katz & Bestoff)
• Longs Drugs
• Medic Drug Inc
• Osco Drug & Sav-on Drugs
• Pay 'n Save
• Peoples Drug
• Perry Drug Stores
• Phar-Mor
• Read's Drug Store
• Reliable Drug
• Revco
• Rexall
• Rx Place – Woolworth
• Sav-on
• Sav-Rite Drug
• Schwab's Pharmacy
• Skaggs Drug Centers
• Snyder Drug Stores
• Standard Drug Company – was part of Melville Corporation
• SupeRx
• Tam's Gold Seal Drugs
• Thrift Drug
• Thrifty PayLess
• Treasury Drug
• Value Giant

Maybe ya'll would like to reconsider that approach

 

[Maineiac]

Thank you Michael. Very helpful. It happens to be NN as the owner is responsible for " the roof, structural and exterior, foundation portions of the Premises including bearing walls & columns." I’ll apply a reserves allowance. I find that cap rates have been trending downward to about 8.18% (NNN), right in the range you indicated. I’ll increase the rate some degree for the NN lease. Have you observed a variable between the NNN & NN rates? I don’t see that the Sales Approach is applicable to this investment property, even as a test of reasonableness. Other thoughts?

Thanks again for your time & help.

 

[Maineiac]

Thanks Mark. I’ve included in my research and the report, the information on tenants credit rating and financial health including comparisons to the other major drugstore chains. Also mapped out local competing stores and will do same-brand. Good suggestions. I had worked up the DCF on this earlier but had a hard time reconciling the results. Finding no current discount rates for the property type (or discussion of discount rates & DCF) I decided not to include it.

 

[Howard Klahr]

If you deduct a reserve allowance and adjust the cap rate you will be double dipping

 

[Ken B]

It is not necessary to make the job harder than it needs to be. Recognizing that the use of terminology may be somewhat different in various area, these properties are typically leased on an absolute net basis, even if the landlord retains some responsibility for maintenance of long-life components. There may be minor variations between leases with regard to tenant/landlord expense responsibilities, but you will need to speak with someone knowledgeable of the lease terms to discern that information.

As maintenance of long-life components would be a capital expense, I would not normally make an allowance for replacement reserves in a DCA and I don't think an investor would do so, either. You could provide an SCA as a check of reasonableness, but most adjustments would be related to location difference which would be reflected in the rent. The only concern to me of any significance is related to renewal of the lease, given its relatively short remaining term. That said, if you believe it reasonably probable that the lease will be renewed, I bet you could find sales of similar properties where the risk associated with lease renewal is reflected in the cap rate indicated for those sales. Cap in-place income, boom, you're done. In your case, you might want to consider the age and condition of the roof and make a line item adjustment, if warranted. But again, such concerns may be reflected in the cap rate of the most similar sales.

Michael S gives good advice. I'll have to talk to him about that.

 

[Michael S]

And how many of these are you aware of? These are just pharmacies, let alone other major retail operations.

• A. L. Price – Metro Detroit; part of Perry Drug Stores
• Arbor Drugs
• Big "B" Drugs
• Cunningham Drug
• Dart Drug – converted to Fantle's
• Disco Drug and Discount Centers
• Drug Emporium
• Drug Fair
• Eckerd Corporation
• Fantle's
• Farmacias El Amal – San Juan, Puerto Rico
• G. O. Guy
• Giant T – owned by Thrifty PayLess
• Gray Drug
• Haag Drugs
• Happy Harry's
• Hook's Drug Stores
• K&B (also known as Katz & Bestoff)
• Longs Drugs
• Medic Drug Inc
• Osco Drug & Sav-on Drugs
• Pay 'n Save
• Peoples Drug
• Perry Drug Stores
• Phar-Mor
• Read's Drug Store
• Reliable Drug
• Revco
• Rexall
• Rx Place – Woolworth
• Sav-on
• Sav-Rite Drug
• Schwab's Pharmacy
• Skaggs Drug Centers
• Snyder Drug Stores
• Standard Drug Company – was part of Melville Corporation
• SupeRx
• Tam's Gold Seal Drugs
• Thrift Drug
• Thrifty PayLess
• Treasury Drug
• Value Giant

Maybe ya'll would like to reconsider that approach

Don't think I've heard of any of these. I doubt any are rated by Standard & Poor's or Moody's. Because they don't have that strong implicit (or explicit) guarantee that comes with a credit rating, I doubt a property with a 10+ year lease to any of those tenants would sell at a cap rate as low as a CVS or Walgreens. That's part of the reason why the leased fee value of your typical drugstore (occupied by CVS or Walgreens) can easily be twice what the fee simple value is. Those tenants are willing to pay a premium for the best corner locations and built to suit buildings. They will also sell at considerably lower cap rates than a typical tenant at market rent.

 

[Michael S]

Thank you Michael. Very helpful. It happens to be NN as the owner is responsible for " the roof, structural and exterior, foundation portions of the Premises including bearing walls & columns." I’ll apply a reserves allowance. I find that cap rates have been trending downward to about 8.18% (NNN), right in the range you indicated. I’ll increase the rate some degree for the NN lease. Have you observed a variable between the NNN & NN rates? I don’t see that the Sales Approach is applicable to this investment property, even as a test of reasonableness. Other thoughts?

Thanks again for your time & help.

In talking to brokers typically I've heard the difference quoted at about 25 basis points. The problem is it's hard to get an apples to apples comparison because most credit tenants have a standard lease structure and when you compare a NN Family Dollar to a NNN Dollar General there's other factors at play like lease term, escalations, and credit rating. Also, with those types of tenants they typically have metal roofs with a 20-year warranty and a longer life expectancy. A drug store usually has a flat roof and by the end of the initial 25-year term it's about due for replacement. I worked on the appraisal of a couple of older Walgreens a few years ago where both had pretty short remaining lease terms, and one needed a new roof. The landlord got them to extend their lease term from 3-4 years to 13-14 (technically they waived some of their termination options they had every five years for a 75-year lease term) in exchange they got a slightly reduced rent, which was already relatively low for a drug store, mid-teens versus a more typical rate for a new location in the mid to upper 20s.