These 2 Deals Show the Divide in Real Estate

Nothing better displays the divide in real estate than two recent commercial real estate sales.

Jan 27, 2014 at 3:54PM

Walgreens New

Source: The Boulder Group.

Near Loyola University sits a Walgreen (NASDAQ:WBA) store like many others. But this isn't your average Walgreen building -- it just set a record: it holds the lowest cap rate on any triple-net building lease.

The Boulder Group sold the property at a cap rate of 4.87%, pricing the roughly $630,000 in annual rents at more than $13 million. 

Real estate rarely sells so expensively, but this is a record-holding property, and the lessee is a quality tenant. In the past few months, three Walgreen stores have sold at cap rates under 5%. In essence, Walgreen can have new stores built to its specifications and rent them for less than 5% of the market value of the property annually.

Last quarter, retail REIT Realty Income Corp. (NYSE:O) reported it purchased several properties at an average initial yield of 7.1%, which is a good proxy for the average single-tenant building.

Not all deals are so favorable
In a separate transaction, a Best Buy (NYSE:BBY) store in Mishawaka, Ind., leased for $7 million. The 10-year lease will provide the buyer with an immediate 10.8% cap rate, a full 5.93 percentage points higher than Walgreen's deal.

The disparity in pricing between Best Buy and Walgreen is a microcosm for the real estate sector as a whole. On one hand, you have a 50,000-square-foot Best Buy situated in a shopping center in a sparsely populated Midwestern town yielding more than 10%. On the other, a small Walgreen store in a high-traffic area next to public transportation and a college campus yielding 4.8%.

What's the difference? It's all risk.

Sure, the Walgreen property is newer. Brand-new, in fact. It's also in a high-traffic area in Chicago, not tucked away in Mishawaka, Indiana. But when push comes to shove, Walgreen is, by far, a better-quality tenant. Besides, a 14,820-square-foot retail store is preferable to a 50,000-square-foot big-box store in a shopping center.

The fact is, single-tenant properties have some of the lowest vacancies in retail. Big-box centers, and shopping centers as a whole, feature some of the highest. If a distressed Best Buy leaves, who can take its place? Sears? J. C. Penney? Slow-growing Wal-Mart? How about Target, which is planning a future based on small, not large, new stores? The reality is, there are very few companies to soak up an oversupply of large retail spaces.

Major Market Retail Vacancies | Infographics

Commercial real estate isn't what it used to be
I wanted to highlight these recent transactions to get to a key point: Commercial real estate is changing rapidly, particularly in retail. Whereas 15 years ago it may have seemed obvious that big-box stores could survive -- and thrive -- against Internet retailers, it doesn't seem to be so obvious now. We can see that realization priced in the spread between Walgreen's leases and Best Buy's -- the big-box store sold with a 6 percentage point spread to Walgreen's record-breaking sale.

This story should be on the minds of every investor. For large-format stores, give a second thought to what a retailer's real estate is actually worth. Sure, a handful of analysts have made the case that Sears is worth more dead than alive based on its real estate portfolio, but who's going to buy it? If it were so valuable, why haven't a number of REITs made bids?

For REIT investors, think more carefully about the properties in your favorite company's portfolio. A single-tenant REIT like Realty Income Corp. is operating in a much better environment than your average retail or mall REIT.

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Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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