Should You Sell Your Rite Aid?
Over the last decade, corporate pharmacy leases have been a highly attractive investment vehicle for investors. These were “low risk” coupon clippers. Because they were viewed as such stable investments, they traded at a low cap rate that made them particularly attractive to 1031 buyers. Such buyers arrived at these properties after rolling equity built over decades through multiple properties.
Who would have thought that the American icon, the pharmacy, would have failed? Truth be told, the pharmacy didn’t fail. The strange and unnecessarily large retail floor is what sunk the ship. Rite Aid built too big and too fast. And now, all at once, the rug as been pulled out from underneath over 1,000 investors.
What should you do with your property? That is a question for you to answer. Hopefully this article helps you think through the most important factors in making the decision whether to pursue a leasing strategy or to sell.
How much time do you have?
This is a tricky question. Rite Aid is closing multiple batches of stores. The termination of those leases is, ostensibly, taking effect in batch fashion as well. Whatever legal notice you receive of the lease termination will include an effective date. Whether that date will be retrospective by the time you receive the notice or forward looking is anyone’s guess. The sooner you begin to act the better.
How much time you have will depend not only on the timing of the lease termination but also on your cash reserves.
How much cash do you have to burn?
If you are a property owner who has lost a triple-net (NNN) tenant, there are four potential pressures on your cash reserves.
NNN costs
Taxes, insurance, and general maintenance add up quickly. In California, it is standard that the property taxes on one of these properties ranges from $70,000 to $140,000 depending on on your basis and local tax code. Insurance may or may not be a concern depending on the lease that was in place and whether you, the owner, elected to maintain a commercial policy bundle. If you did not, then you will need a policy – particularly if there is a loan on the property. Maintenance may not, at first glance, seem to be a significant item. The cost, however, of maintaining the property in marketable condition is substantial.
Before considering outstanding debt, leasing commissions, and TI allowance(s), you should budget $100,000 - $170,000 (per year) to cover operating costs.
Debt
Many owners acquired their building with debt. Some may have employed a higher LTV note while others are subject to relatively low leverage. Owners who 1031 Exchanged into a Rite Aid investment often tacked on a loan to their sale proceeds to fund the gap between those proceeds and the target. The size and structure of the loans that exist on these buildings surely varies significantly. Understanding how your loan impacts your carry cost is, however, essential.
Recently I was looking at a particular property and estimated that carry costs were in the ballpark of $30,000/month. When I got on the phone with the owner’s agent, he confirmed that the Landlord was carrying about $25,000/month. Luckily, this owner was prudent and started saving money over the last year or two in preparation for this kind of event. Still, preparation can only survive $25,000/month for so long.
Leasing commission(s)
Many owners who buy a leased investment have never gone through the process of marketing a property for lease and utilizing a leasing agent. It is very similar to selling a property insofar as the real estate agent gets paid – not out of the proceeds of a sale but out of the value of the lease over its term. A lease commission on a large single-tenant lease for a vacant Rite Aid could be as high as $350,000. That is a big chunk of cash. If you were to renovate the property to accommodate multiple tenants, the pain of paying leasing commissions could be spread out, but that comes with the pain of more carry costs.
If you decide that you want to lease the property using an agent but you are strapped for cash, one solution is to structure the commission to be paid in installments. This method typically sets aside a portion of the base rent that gets paid to the agent. There are countless permutations of this structure. What is important to note is that you can pay the commission out of base rent.
Tenant improvement allowance(s)
Different tenants will have different needs and expectations. Attracting good tenants, however, will require that you, the landlord, contribute something toward their tenant improvements. This is particularly true for medical tenants and tenants building kitchens that will create lasting value past the lease term. I have seen TI allowances for medical as high as $40/SF. General retail will be significantly lower than that. Still, a TI allowance of $10/SF over a 17,000SF building is $170,000 that will likely have to be paid out within 12-18 months of commencing the lease.
There are other levers that can be pulled to entice the tenant. If you think of the deal as a balloon, you can push the balloon in different spots but the balloon stays the same size. Perhaps you cannot offer the most competitive TI allowance. You might consider offsetting this competitive disadvantage by offering a larger period of rent abatement or compromising on price.
Worst case scenario, you have a property with high triple-nets, debt, a difficult lease market with needy tenants. Best case scenario. you get the property leased within 12 months of losing Rite Aid.
Key Question: Can you afford to carry the property for 12 months with no tenant, to pay a leasing commission, and to offer a TI allowance that will attract the quality tenant that will resurrect the value of your property?
Is now the time to exit?
For many owners, selling will be the only option. Carrying the property and getting it leased is simply too expensive. This may be you. If it is you, then the best advice that I can give is that you hire an MAI designated appraiser to value your property. Have the appraiser value your property via (1) Sales Comparison Approach and (2) Income Approach using market rent data. Understanding what the property is worth (1) as vacant and (2) as leased will allow you to competitively market the property and negotiate with potential buyers.
If you need help navigating this process, contact us for a free consultation.
What if my building is worth less than what I paid for it?
While it is hard to sell for less than you spent on the property, here are a few considerations:
Your capital loss can be used as a tax deduction on other income. Consult a tax professional for details and how cashing in on a capital loss could be used most strategically.
The proceeds of the sale should be tax free. Whether you plan to use the proceeds to purchase another real estate investment or to put it in the bank, there is almost certainly no tax burden incurred by selling.
Maintain and increase your cash reserves. Your cash reserves may be able to handle a long carry period and leasing expenses. If not, selling will avoid plunging you into financial hardship.
What do we learn?
There is no such thing as a “sure investment”. Investing is inherently risky. While it is temping to squeeze as much income as possible out of an investment property, it is wise to keep a substantial fund available for black swan events. If you never have to use it, then you can eventually cash out. If you have to use it, you will be thankful you were disciplined to save that money.
