There are 3 major drugstore chains in the US: Walgreens, CVS, and Rite Aid. The table below ranks the companies by market capitalization and sales revenue as of September 2009:

 

  1. Walgreens ranks #1 with market cap of $34.26 Billion, $62.23 Billion in revenue, and S&P rating of A+. According to Walgreens, 75% US population lives within 3 miles from its stores. On Oct 1, 2009, Walgreens opened its 7000-th store in Brooklyn, New York.
  2. CVS ranks #2 with market cap of $52 Billion, $93.27 Billion in revenue (CVS revenue alone is less than Walgreens if revenue from its Caremark group is taken out), and S&P rating of BBB+. CVS opened its 7000-th store in Little Canada, Minnesota on October 5, 2009.
  3. Rite Aid ranks #3 with market cap of $1.87 Billion, $26.21 Billion in revenue, 4901 stores and S&P rating of B-.

 

Investors purchase properties occupied by these drugstore chains for the following reasons:

 

  1. The drugstore business is very recession-insensitive. People need medicine when they are sick, regardless of the state of the economy. Both rich and poor people in the US have access to medicine. Some even argue that low-income people use more medicine due to free or low-cost drugs offered by government-assisted programs. So the tenants should do well during tough time and have money to pay rent to landlords.
  2. The drugstore business has a good prospect in the US:
    • People are living longer and need more medicine to sustain longevity, e.g. Actonel for osteoporosis, Aricept for Alzheimer's symptoms. Older people tend to use more medicine than younger ones. As the 78 million baby boomers are getting closer to retiring age starting from 2008, the drugstore chains anticipate the demand for medicine to increase in next 20 years.
    • The drug market continues to expand as the US population will continue to grow.
    • There are new drugs to treat previously untreatable illnesses, and new diseases, e.g. Viagra for men's unhappiness, Zoloft for depression, Avastin for colon cancer, Herceptin for breast cancer, Nicotine patches for smokers to kick the habit, Tamiflu for a potential bird flu pandemic, vaccine for swine (H1N1) flu pandemic, Tekturna/Rasilez for hypertension and various new drugs for AIDS and Attention Deficit Disorder (ADD). The new medicines are very expensive, e.g. a year's supply of Avastin costs about $55,000. Eli Lilly has sold about $4.8 billion of Zyprexa in 2007 for schizophrenia and yet most people have never heard of this medicine.
    • There are existing drugs now approved to treat new illnesses and thus increase their sales revenue. For example, Lyrica was originally intended to treat pain caused by nerve damage in people with diabetes. It is now approved by FDA to treat Fibromyalgia which affects 5.8 million Americans per WebMD.
    • Big advances in genetics, biology and stem cells research are expected to produce a new class of drugs to treat diabetes, Parkinson's and various rare genetic disorders. For example the new drug Ilaris from Novartis targets genetic causes of an inherited disorder that there are only 7000 known cases worldwide. However, Novartis hopes to gradually broaden its drugs to a blockbuster drug to more common disorders caused by similar genetics.
    • Technology and modern life introduce and require new products, e.g. pregnancy test kits, Lamisil for stronger clearer toe nails, Latisse for longer thicker eyelashes, Premarin for menopausal symptoms, diabetic monitors, electronic toothbrushes, contact lenses, lenses cleaners, diet pills, vitamins, birth-control pills, IUDs, nutrition supplements and Cholesterol-lowering pills (Americans spent nearly $26B in 2006 on Cholesterol medications alone per IMS Health, a Connecticut-based consulting company that monitors pharmaceutical sales.) There are also more surgeries: C-sections, Kidney transplants, open-heart triple by-pass, and breast augmentations. More surgeries mean more medicines are needed such as Vicodin for pain management and Warfarin to prevent blood clots in surgeries.
    • Before the customers can get to the medicine aisles or pharmacy counters, they have to pass by chocolates, sodas, digital cameras, watches, toys, dolls, beers and wines, cosmetics, video games, flowers, fragrances, and greeting cards. They hope you use the one-hour photos services and exchange your liquid propane tanks there. The stores also carry seasonal items, e.g. Halloween costumes, and "As Seen on TV" merchandise, e.g. Shamwow. As a result, customers buy more than their prescriptions and medicine in these drugstores. Rite Aid sells more 28,000 non-pharmacy items in its stores while Walgreens has 22,000 different items on store shelves. CVS reported that non-pharmacy sales represented 30% of the company's total sales in January of 2007. The figure for Walgreens is 34% and 37% for Rite Aid. Many pharmacy locations are in effect convenience stores especially ones that are in residential or rural areas. During the recession, sales of these items are down as customers buy what they need and not what they want. Walgreens tries to reduce the number of items by 4000. It also introduces its own private label which has higher profit margins.
    • There are more and more generic medications on the market as a number of enormously popular brand-name blockbusters will lose their 20-year long patents, e.g. Lipitor (best selling drug in the world to lower cholesterol) in 2010, Viagra (you know what it's for) in 2012. Drugstores prefer to sell generic drugs to customers due to higher profit margins than the brand-name medications.
    • Some people are addicted to pain killers, e.g. Hydrocodone and consume a large amount of medicine, e.g. 30-day dosage in a day to get high. According to testimony from the National Institute on Drug Abuse, US retail pharmacies dispensed nearly 180 million prescriptions in 2007 for opiates, e.g. Hydrocodone.
    • This author estimates that at least 10% of the dispensed prescription drugs are not used and sit idle in the medicine cabinets. They are eventually expired and thrown away.
  3. These companies sign very long-term, NNN leases, guaranteed by their corporate assets. This makes the investment in the underlying property fairly low risk, especially for Walgreens with an A+ S&P rating. In fact, these properties are sometimes referred to as investment-grade properties. Once the drugstore chains sign the lease, they pay the rent promptly and timely. This author is not aware of any properties leased by one of these drugstore chains in which the tenants failed to pay rents. Even when the stores are closed due to weak sales (Walgreens closed 119 stores in 2007), these companies may sublease the properties to other companies and continue to pay rents on the master leases.

Investment Risks
Although the pharmacy business in general is recession-insensitive, there are risks involved in your investment:

 

 

  1. The main downside about investing in pharmacies is there is little or no rent bump for a long time, e.g. 20-50 years, especially for Walgreens. So the rent is effectively reduced after inflation is factored in. This is one of the main reasons these properties do not appeal to younger investors.
  2. The 3 drugstore chains now have a new formidable competitor, Wal-mart. Wal-mart sells prescription drugs in more than 4000 Wal-mart, Sam's Club and Neighborhood Market stores in 49 states. The retail giant is known for launching in 2006 a highly-publicized $4 generic prescription drug program which now sells 350 generic medications for a 30-day supply. The actual number of medications is less as the medications with different strengths are counted as different medications. For example, Metformin 500 mg, 850 mg, and 1000 mg are counted as 3 medications. Wal-mart probably makes very little profits on these medications if any. However, the marketing campaign generates a lot of publicity for Wal-mart (Target now offers the same medications for $4 but few people know about it.) Wal-mart hopes to draw customers to its stores with other prescriptions where it has higher profit margins. In an unscientific survey with just one brand-name prescription of Lyrica, this author finds the lowest price at Costco, the highest price at Walgreens and Wal-mart at the middle.
  3. Chief Business Correspondent Rick Newman from US World & News Report predicted that Rite Aid might not survive in 2009. It looks like he might be wrong. The study by Audit Integrity gave Rite Aid about a 10.5 percent chance of filing for bankruptcy in 2010. However, its stocks seem to perform quite well in the second half of 2009. For the second quarter ended in August 2009, Rite Aid narrowed its loss to $116 million, compared with a loss of $222 million last year.
  4. Drugs are also sold in thousands of supermarkets, Target, and Costco.
  5. Many leases in areas with hurricanes and tornados are NNN leases with the exception of roof and structure. So if the roof is damaged, you will have to pay for the expenses.

 

Among 3 drugstore chains, Walgreens and CVS pharmacies in general have the best locations-at major intersections while Rite Aid has less than premium locations.

Walgreens: the company was founded in 1901 by Charles Walgreen, Sr. in Chicago. While the company has existed for more than 100 years, most stores are only 5-10 years old. This is the best managed company among the three drugstore chains and also among the most admired public companies in the US. The company has been run by executives with proven track records and hires the top graduates from universities. Due to its superior financial strength--S&P A+ rating-- and premium irreplaceable locations, properties with leases from Walgreens get the highest price per square foot and/or the lowest cap rate among the 3 drugstore chains. In addition, Walgreens gets flat rent or very low rent increase for 20 to 60 years. The cap rate is often in the low 6% to 7.5% range in 2009. Investors who buy Walgreens tend to be more mature, i.e. closer to retirement age. They are looking for a safe investment where it's more important to get the rent check than to get appreciation. They often compare the returns on their Walgreens investment with the lower returns from US treasury bonds or Certificate of Deposits from banks. Walgreens opened many new stores in 2008 and 2009 and thus you see many new Walgreens stores for sale. It will slow down this expansion in 2010 and focus on renovation of existing stores instead

CVS: CVS Corporation was founded in 1963 in Lowell, MA by Stanley Goldstein, Sidney Goldstein, and Ralph Hoagland. The name CVS stands for "Consumer Value Stores". As of 2009, CVS has about 6300 stores in the US, mostly through acquisitions. In 2004, CVS bought 1,200 Eckerd Drugstores mostly in Texas and Florida. In 2006, CVS bought 700 Savon and Osco drugstores mostly in Southern California. And in 2008 CVS acquired 521 Longs Drugs stores in California, Hawaii, Nevada and Arizona for $2.9B dollars. The acquisition of Long Drugs appears to be a good one as it CVS does not have any stores in Northern CA and Arizona. Besides, the price also included real estate. It is also bought Caremark, the largest pharmaceutical services company and changed the corporation name to CVS Caremark. When CVS bought 1,200 Eckerd stores, it formed a single-entity LLC (Limited Liability Company) to own each Eckerd store. Each LLC signs the lease with the property owner. In the event of a default, the owner can only legally go after the assets of the LLC and not from any other CVS-owned assets. Although the owner loses the guaranty security from CVS corporate assets, this author is not aware of any incident where CVS closes a store and does not pay rent.

Rite-Aid: Rite Aid was founded by Alex Grass (he just passed away on Aug 27, 2009 at the age of 82) and opened its first store in 1962 as "Thrif D Discount Center" in Scranton, Pennsylvania. It officially incorporated as Rite Aid Corporation and went public in 1968. By the time Alex Grass stepped down as the company's chairman and chief executive officer in 1995, Rite Aid was the nation's largest drugstore chain in terms of total stores and No. 2 in terms of revenue. His son, Martin Grass, took over but was ousted in 1999 for overstatement of Rite Aid's earnings in the late 1990s. Rite Aid is now the weakest financially among the 3 drugstore chains. In 2007, Rite-Aid acquired about 1,850 Brooks and Eckerd drugstores, mostly along the East coast to catch up with Walgreens and CVS. In the process, it added a huge long term debt (currently owes over $5.69 Billion) and is the most leveraged drugstore chain based on its market value. The integration of Brooks and Eckerd did not seem to go well. Revenue from some of these stores went down as much as 20% after they change the sign to Rite Aid. As of 2009, Rite-Aid has over 4900 stores and over $26 Billion in revenues. On January 21, 2009 Moody's Investor Services downgraded Rite Aid from "Caa1" to "Caa2", eight notches below investment grade. Both ratings are "junk" which indicate very high credit risk. Rite Aid contacted a number of its landlords in 2009 trying to get rent concession to improve the bottom line. In June 2009, Rite Aid successfully completed refinancing $1.9 Billion of its debts. In September 2009 Rite Aid reported a lower loss for the second quarter ended in August 2009.

Things to consider when invested in a pharmacy

If you are interested in investing in a property leased by drugstore chains, here are a few things you should consider:

  1. If you want a low risk investment, go with Walgreens. In stable or growing areas, the degree of safety is the same whether the property is in California where you get a 6% cap or Texas where you may get a 7.5% cap. So, there is no significant advantage to invest in properties in California as the property value is based primarily on the cap rate. In 2009, the offered cap rate for Walgreens seems to increase about 1% compared to previous years. So you might be able to get some appreciation in your investment when you sell at a lower cap rate in the future.
  2. If you are willing to take more risk, then go with Rite-Aid. Some properties outside of California may offer up to 10.75%% cap rate in 2009. However, among the 3 drug chains, Rite Aid has 10.5% chance of going under in 2010. Should it declare bankruptcy, Rite Aid has the option to pick and choose which locations to keep open and which locations to terminate the lease. To minimize the risk that the store is shuttered, choose a location with strong sales and low rent to revenue ratio.
  3. If you are not a conservative investor or risk taker, you may want to consider a CVS pharmacy. It has BBB+ S&P credit rating. Its cap rate is higher than Walgreens but lower than Rite Aid. Some leases may offer better rent bumps. On the other hand, some CVS leases, especially for properties in hurricane areas, e.g. Florida are not truly NNN leases where landlords are responsible for the roof and structure. So make sure you adjust the cap rate down accordingly. Some of the CVS locations have onsite Minuteclinic staffed by registered nurses. Since this clinic idea was introduced recently, it's not clear having a clinic inside CVS is a plus or minus to the bottom line of the store.
  4. All 3 drugstore chains have similar requirements. They all want highly visible, standalone, rectangular property around 10,000 - 14,500 SF on a 1.5 - 2 acre lot, preferably at a corner with about 75 - 80 parking spaces in a growing and high traffic location. They all require the property to have a drive-thru. Hence, you should avoid purchasing an inline property, i.e. not standalone and property with no drive-thru windows. There is a chance that these drugstores may not want to renew the lease unless the property is located in a densely-populated area with no vacant land nearby. In addition, if you acquire a property that does not meet the new requirements, for example a drive-thru, you may have a problem getting financing as lenders are aware of these requirements.
  5. If the pharmacy is opened 24 hours a day, it is in a better location. Drugstore chains do not open the store 24 hours day unless the location draws customers.
  6. Many properties may have a percentage lease, i.e. the landlord can get additional rent when the store's annual revenue exceeds a certain figure, e.g. $5M. However, the revenue used to compute percentage rent often excludes a page-long list of items, e.g. wine and sodas, tobacco products, items sold after 10 PM, drugs paid by governmental programs, etc. The excluded sales revenue could account for as much as 70% of store's gross revenue. As a result, this author has seen only 1 store in which the landlord is able to collect additional percentage rent. The store with a percentage rent is required to report its monthly sales to the landlord. As an investors, you want to invest in a store with strong gross sales, e.g. over $500 per square foot a year. In addition, you also want to check the rent to revenue ratio. If the figure is in the 2-4% range, the store is likely to be very profitable so the chance the store is shut down is low.
  7. It does not matter how good the tenants are, avoid investing in declining and/or low-income areas or small towns with less than 30,000 residents within 5 miles ring. In a small town, it may be the only drug store in town and captures most of the market share. However, if a competitor opens a new location in the area, revenue may be severely affected. These properties are easy to buy now and hard to sell later. In 2009 where the credit market is tight, you may have problems finding a lender to finance these properties.
  8. Many properties have an existing loan that the buyer must assume. If you have a 1031 exchange, think twice about buying this property. You should clearly understand loan assumption requirements of the lenders before moving forward. Should you fail to assume the existing loan (assuming an existing loan is a lot more difficult than getting a new loan), you may run out of time for a 1031 exchange and may be liable to pay capital gain.
  9. With few exceptions, drugstore chains do not own the stores they occupy for several reasons. Here are just a couple of them:

  • They know the pharmacy business but don't know real estate. Stock investors also don't want Walgreens to become a real estate investment company.
  • Owning the real estate will require them to carry lots of long term debts which is not a brilliant idea for a publicly-traded company.

  • About 10% of the drugstore properties for sale and typically CVS pharmacies require very small amount of equity to acquire, e.g. 10% of the purchase price. However, you are required to assume an existing fully-amortized loan with zero cash flow. That is, all of the rent paid by the tenant must be used to pay down the loan. The cap rate may be in the 7% range, and the interest rate on the loan could be attractive in the 5.5% to 6% range. Hence, the investor pays off the loan in 10 to 20 years. However, the investor has no positive cash flow. This requires you to come up with outside cash to pay income tax on the rental profits (the difference between the rent and mortgage interest). The longer you own the property, the more outside cash you will need to pay income taxes as the mortgage interest will get less and less toward the end. So who would buy this kind of property?
    • The investors who have substantial losses from other properties or stocks market. By acquiring this zero cash flow property, they may offset the income from the drugstore tenant against the losses from other properties or stocks market. For example, a property has $105,000 of rental profits a year, and the investor also has rental losses of $100,000 from other properties. As a result, the combined profits are only $5,000.
    • The uninformed investors who fail to consider that they have to raise additional cash to pay income taxes.

    Out of the Box Thinking

    If you put too much weigh on the S&P rating of the tenants, you may end up either taking a lot of risks or passing up good opportunities.

     

    1. Good location should be the key in your decision on which drug store to invest in. It's often said a lousy business should do well at a great location while the best tenant will fail at a lousy location. A Walgreens store that is closed down later on (yes, Walgreens closed 119 stores in 2007) is still a bad investment even though Walgreens continues paying rent on time. So you don't want to blindly invest in a drug store simply because it is a Walgreens.
    2. No company is crazy enough to close a profitable location. It does not take a rocket scientist to understand that a financially-weak company like Rite Aid will make every effort to keep a profitable location open. On the other hand, a financially-strong Walgreens will need justifications to keep an unprofitable location open. So how do you determine if a drug store location is profitable or not if the tenant is not required to disclose its profit & loss statement? The answer is you cannot. However, you can make an educated guess based on store's annual gross revenue is often reported to the landlord as required by the percentage clause in the lease. With the gross revenue, you can determine the rent to income ratio. The lower the ratio, the more likely the store is profitable. For example, if the annual base rent is $250,000 while the store's gross revenue is $5M then the rent to income ratio is 5%. As a rule of thumb, it's hard to make a profit if this ratio is more than 8%. So if you see a Rite Aid with 3% rent to income ratio then you know it's likely a very profitable location. In the event Rite Aid declares bankruptcy, it will keep this location open and continue paying rent. If you see a Rite Aid drug store with 3% rent to income ratio offering 11% cap, chances are it's a low risk investment with good returns. The weakness of corporate guaranty from Rite Aid is probably not as critical and the risk of having Rite Aid as a tenant is not really that significant.

     

David V. Tran is the President and Chief Investment Advisor at Transmercial (formerly eFunding, Inc.), a commercial real estate & loan brokerage company in San Jose, CA. His website is http://www.transmercial.com. He may be contacted at  (408) 288-5500  (408) 288-5500 .




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