Why Rite Aid’s Bankruptcy May Change Investment Real Estate
November 23, 2023
Rite Aid - leased properties were one of the more desirable single tenant net leased (STNL) investments across Central PA over the past 20 years.
They were headquartered in Camp Hill (now Philly) and were among the top 3 drugstore chains in the United States – ranking 94 on the Fortune 100 largest U.S. companies by revenue in 2018.
As of October 2019, Rite Aid’s long - term debt obligations had a credit rating of “B - “ according to Fitch Ratings.
As of November 2023, it was rated “D” amidst an October 2023 Chapter 11 bankruptcy announcement. [1]
The timeline of the credit downgrades is summarized below:
Among many other reasons for the operational struggles are
1) lawsuits related to the opioid epidemics, and
2) increased competition with CVS, Walgreens and Amazon.
This background is necessary to properly understand the correlation between credit rating and cap rates of net leased properties occupied by Rite Aid between 2019 and November 2023 (date of this article).
Between 2019 and 2022, Rite Aid STNL properties with 5 + years remaining on term commanded cap rates between approximately 6.00% and 7.50% - depending on location and lease term.
Buyers for these types of net leased assets were typically institutional buyers, family offices, and private equity.
In October 2023, Rite Aid announced the closing of 154 stores nationwide (7% of total stores nationwide) with 40 being in Pennsylvania.
The downgrade in credit as a result of the bankruptcy announcement coupled with store closures has certainly increased the perceived risk of Rite Aid net leased assets throughout the country – so much so that STNL assets occupied by Rite Aid are essentially no longer “cap rate deals”.
As a result of the volatility related to Rite Aid’s credit in 2023, do you suspect that the owners of the other 2,000+/- stores across the country think their property values have increased, decreased, or stayed the same?
It’s very clear that property values of Rite Aid net leased assets have decreased in 2023 – irrespective of the interest rate volatility that exacerbates the decline in values.
This leads to the purpose of this article and a widely debated concept in the real estate appraisal industry: dark store theory.
Dark store theory contends that what you’re purchasing is a combination of real estate and intangibles, respectively, when purchasing real estate occupied by credit tenants.
In other words, you used to pay a premium for Rite Aid occupied buildings due to their creditworthiness – not necessarily the fundamental value of the real estate.
Fast forward to November 2023 and the above-refenced credit premium has all but evaporated – translating into huge discounts to Rite Aid-occupied properties (8.00%+ caps in most cases in our area regardless of lease term).
With the above example in mind, did the fundamentals of the real estate change? Not at all. These discounts can be solely attributed to the credit risk of the tenant. This begs the question: were the 6.00% to 7.50% cap rates appropriate for the real estate all along? The answer to that is also probably “no” in most cases.
The below diagram attempts to display the fundamental underwriting of these types of assets:
The first example displays value based on artificially high rental rates as a result of build to suit arrangement as well as artificially deflated cap rates as a result of perceived creditworthiness.
The second example displays fundamental demand of the real estate. The deviation in gross income between Rite Aid and a 2nd generation user acknowledges differences in demand and desirability – the theory being that 2nd generation users wouldn’t value these building improvements on a dollar-for-dollar basis of the cost required to construct them. [2]
The above example is extremely hypothetical but intends to show the consequence of declining property values as a result of declining creditworthiness. As you read this, whether it’s to this extreme, greater, or lesser, owners of Rite Aid-occupied property are evaluating their options and exit strategies in a similar fashion as shown above.
It's important to make the clear distinction between distressed real estate and the point of this article which is separating fundamental real estate value from the contributory value of tenant credit premium, if any.
Artificially high rental rates coupled with artificially low cap rates can pose an undeniable risk to a buyer that doesn’t understand these concepts. An analogy to this risk profile is when single-family rentals are purchased with the intent to utilize them as short-term rentals (STRs).
In some cases, there is increasingly high risk of a municipality terminating STR’s as permitted uses.
Therefore, unless the deal “pencils” as a long - term rental, the investment might not generate enough income to satisfy the monthly/annual debt obligations. Although I’m conflating a legal argument with a credit argument, these are each externalities to the real estate that should be perceived as such.
Implications for Market Participants
Rite Aid is a recently attractive net investment with a national footprint whereby owners recently lost significant equity as a result of downgraded credit. This scenario highlights the importance of separating the fundamentals of the underlying real estate with intangibles when underwriting similar opportunities. At the expense of Rite Aid, this may change the way we understand real estate and intangibles as it relates to a net leased asset occupied by a “credit” tenant.
Implications of this concept include:
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Real estate tax assessments (positive effect)
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Real estate transfer tax (positive effect)
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Impact on income taxes based on differences in depreciation of real estate and amortization of intangible (positive effect)
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Bank financing/underwriting (negative effect)
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Real estate sales brokers (relatively unaffected)
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Sales prices will not necessarily change, but the accounting/breakdown of price will
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May need to communicate sale/list prices differently:
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Ex: “Listing is based on a combination of real estate and credit premium.”
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As an owner or some other interested party, you may have found yourself looking at the same property through different lenses depending on the situation.
Take this scenario for example: as a borrower, I’d want the bank to view the intangibles as being part of the consideration paid for the real estate – thereby increasing my debt proceeds.
But as an owner, I’d like the tax assessors to view the intangible value separately and only tax me on the value of the real estate.
Conclusion
If there was more money to be saved on RE taxes, transfer taxes, and impact on income taxes than the opportunity cost of lower debt proceeds, it is likely that market participants would be more accepting of separating real estate and intangibles.
However, it is likely more advantageous for the general market to perceive them together to “manipulate” the debt markets.
Regardless of how you handle these valuation scenarios as a real estate professional, the consensus on this topic will be an interesting trend to follow as property taxes continue to rapidly increase to fund public projects, fund increasing social needs, and act as an outlet for balancing local budgets. Not to mention increasingly aggressive school districts “reverse appealing” property assessments.
Disclaimer: It is important to keep in mind that the above methodology may be theoretically correct, but practically irrelevant. It’s an appraiser’s job to mirror the market, not to tell the market how it should be behaving. Regardless of how you feel, this is an important concept to understand in order to appropriately assign varying levels of risk to different categories of assets: especially real estate and intangibles, respectively
Additional reading also includes “Is Excess Rent Intangible” by Stephen Roach, MAI.
I can provide the PDF if requested.
[1] https://www.fitchratings.com/entity/rite-aid-corporation-81657872#ratings
[2] For further reading on how lease structures are established for build-to-suit agreements, please visit: Build-to-Suit Transcends Real Estate
Michael J. Rohm, MAI, CCIM, R/W-AC, is a fee appraiser and real estate agent working throughout Pennsylvania.
He is president and owner of Commonwealth Commercial Appraisal Group and is director of valuation advisory and senior associate with Landmark Commercial Realty. Contact him at mrohm@commonwealthappraiser.com.
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