Cap rates for single tenant CVS, Rite Aid and Walgreens properties reached a new historic low in the net lease drug store sector in the third quarter of 2015.
Cap rates continued to decline as investors flock to the net lease space’s cornerstone asset, drug stores. With historically low cap rates, the drug store property supply has increased drastically by over 20% as owners attempt to take advantage of unprecedented high values. While overall cap rate levels experienced compression, short term leased Rite Aid properties with 5-9 years of lease term remaining had the greatest cap rate compression of 85 basis points in the third quarter of 2015. New construction CVS properties experienced the second greatest compression of 50 basis points to a 5% cap rate, the same level for new construction Walgreens assets. These levels can be attributed to the historically low interest rate environment coupled with high demand amongst 1031 exchange buyers for long term leased properties in a market constrained by limited expansion plans for drug stores tenants.
With cap rates for Walgreens and CVS at all-time low levels, the ratio of long term leased drug store properties (20 years or more) to the total supply has decreased when compared to the third quarter of 2014 and total overall supply of long term leased drug stores declined by 27% in the same time period.
As Rite Aid’s financial strength improves, investors have gained interest in the extra yield associated with Rite Aid properties. The additional yield is attributed to Rite Aid not being an investment grade rated company similar to Walgreens or CVS. However, with improving company fundamentals, cap rates for Rite Aid properties decreased by 77 basis points since the third quarter of 2014.
Transaction velocity for 2016 in the net lease drug store sector should remain at a similar pace to 2015 as drug stores continue to be at the forefront of investor demand. As cap rates for new construction properties with long term leases continue to compress, expect 1031 exchange buyers and private investors to remain the primary buyer. It has become increasingly difficult for institutional investors to acquire long term leased drug stores due to the low cap rates associated with these properties. Additionally, investors searching for higher yields for drug store properties will seek short term leased assets with strong store sales.
About the author: Randy Blankstein is President of net lease advisory firm The Boulder Group.