Journal of Property Economics

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1 Keith E. Darin, MAI is a Director in the Valuation & Financial Opinions Group at Stout Risius Ross, Inc. His concentration is in real estate valuation and consulting. He is licensed as a certified general real estate appraiser in Illinois, Michigan, Ohio, Nevada, and Florida. Mr. Darin s commercial real estate valuation and consulting experience includes assignments completed for local, national, and international clients for a variety of purposes. In addition to real estate valuation and consulting, Mr. Darin also has experience in business valuation. Mr. Darin earned a Bachelor of Arts in Finance from Michigan State University. He is a designated member of the Appraisal Institute and is a Director on the Board of the Great Lakes Chapter of the Appraisal Institute. Drug Store Valuation: Important Issues to Consider for Ad Valorem Taxation Keith E. Darin, MAI Over the last ten to fifteen years, major drug retail companies, including Walgreens, CVS, and Rite Aid, changed their storefront profiles from the traditional leased space in community or neighborhood retail strip shopping centers to the freestanding retail drug store typically located at the corner of high-traffic corridors. Walgreens led the way; 10 percent of its retail stores were located in freestanding locations in 1990, increasing to more than 80 percent of its total stores in CVS and Rite Aid increased their freestanding store locations as a percentage of total stores from 20 percent and 40 percent in 1997 to 50 percent and 55 percent in 2004, respectively. 1 The purpose of this transition was to increase exposure to passing automobile traffic and improve convenience for customers. How Did They Do It? The drug store chains expanded their market reach with freestanding buildings by purchasing land at primary intersections and constructing new stores. Once the buildings are constructed, long-term leases are created with the drug store retailers. The lease agreements often reflect rental rates on an absolute net basis, whereby the tenant is responsible for all operating expenses of the property, including capital improvements during the term of the lease. The properties are then sold to investors, or they may be packaged with other newly constructed retail drug stores and sold in sale-leaseback transactions. The trends in freestanding retail drug store development present some complicated valuation issues for this 3

2 property type, particularly in arriving at a value of the real property for ad valorem taxation. The valuation issues primarily center around the interpretation of the definition of market value for the property and whether it should be based on a market value in use or a market value in exchange. This also generates questions about the property rights that are being appraised under each interpretation. This article presents the differences in the valuation approaches applied under market value in use and market value in exchange and discusses the issues that should be considered in the valuation. Defining Key Terms Value in use is defined as The value a specific property has to a specific person or specific firm as opposed to the value to persons or the market in general. Special-purpose properties such as churches, schools, and public buildings, which are seldom bought and sold in the open market, can be valued on the basis of value in use. The value in use to a specific person may include a sentimental value component. The value in use to a specific firm may be the value of the plant as part of an integrated multiplant operation. 2 When considered relative to the valuation of drug stores, this definition indicates that the value of the real property may be more valuable to the drug store companies than to the market in general due to factors related more to business value than real property value. For example, the amount of retail revenue that can be generated from a specific location may affect the value of the real property to a specific user, because that user may be willing to pay more for the land or pay more in rent to operate a business in that specific location than will be paid by the market in general. Exchange value is defined as follows: In economics, the attribution of value to goods or services based on how much can be obtained for them in exchange for other goods and services. Market Value as an appraisal concept is a type of exchange value. 3 The concept of exchange value in the valuation of drug stores often leads to the conclusion that the real property must be analyzed as a facility that is vacant and available for sale in the open market to a general retail user, rather than to a drug retailer. The differences between value in use and exchange value also create questions about whether the fee simple estate or the leased fee estate is being appraised when considering the longterm leases in place at freestanding drug stores. The concept of uniformity in assessment, denotes assessed values that bear the same relationship to market value, or another value standard, as all other assessments in the tax district; implies equalization of the tax burden. 4 This is an important concept applied in arriving at assessments for real property. As such, the appropriate property rights appraised for ad valorem taxation are best reflected in the fee simple estate, which represents absolute ownership of the property, unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat. 5 The leased fee interest in a property is an ownership interest held by a landlord with the rights of use and occupancy conveyed by lease to others. The rights of the lessor (the leased fee owner) and the lessee are specified by contract terms contained within the lease agreement. 6 Therefore, any value reached for a property that is encumbered by a long-term lease, where the 4

3 contract rent is used in the analysis, is a value of the leased fee interest. It is possible to arrive at a value of the leased fee estate that is higher or lower than the fee simple estate when appraising a property that is encumbered by a long-term lease. The key question is whether or not the rental rate in place at the property reflects a market rent. If a property is encumbered by a longterm lease whereby the contract rental rate is equivalent to market, then the value of the leased fee interest in the property will be equal to the value of the fee simple interest. However, if the rental rate is determined to be above market or below market, then the value of the leased fee interest will be different from the fee simple interest, because the landlord has either a favorable or unfavorable economic position that is dictated by the terms of the lease contract. Therefore, market rent becomes a primary concern in the valuation of drug stores, especially under the application of the income capitalization approach for ad valorem taxation. Income Capitalization Approach The income capitalization approach is the most applicable approach in valuing income-producing properties. Retail drug stores are most often leased rather than owner occupied and, therefore, are most often income-producing properties. The key components that determine the value conclusion for a drug store via the income capitalization approach are the rental rate for the property (either contract or market rents) and the capitalization rate. The operating expenses for a retail drug store are not a critical factor in the valuation, because many of the leases are set up on a triple net basis or on an absolute net basis. A triple net lease typically requires the tenant to pay all of the operating expenses of the property except capital improvements (e.g., replacement of exterior walls and roof). An absolute net lease typically requires the tenant to pay all operating expenses, including capital improvement items. Therefore, the net operating income of the property is not significantly affected by changes in operating expenses, because the tenant is either reimbursing the landlord for these expenses or paying for them directly over the term of the lease. The conclusion for market rental rate for drug stores can be quite different under the premise of market value in use versus market value in exchange. Under a value in use scenario, the most appropriate rent comparables will be other freestanding drug store properties that are leased and occupied by drug store retailers. Contract rental rates for freestanding retail drug stores typically range from $18 to $30 per square foot on a triple net or absolute net basis and have an initial contract term that is typically between twenty and twenty-five years. This rental rate is high compared to rental rates for national retail drug stores leasing space in community or neighborhood retail shopping centers. The median rental rates are $8.81 per square foot on a triple net basis, with the top 10 percent of tenants paying an average of $15.11 per square foot. In addition, the terms are typically for shorter periods, such as ten to fifteen years. 7 Several factors influence the higher rental rate being paid for the freestanding stores versus the in-line spaces in shopping centers. The first is the location of the freestanding store, which is typically on the corner of major corridors with high traffic counts. This location provides greater visibility and easier access from passing traffic. In addition, the freestanding stores may also be located as out parcel properties to existing retail shopping centers. Both of these factors are specifically a 5

4 result of the features and benefits of the real estate. Other factors influencing contract rents that are more tied to the business value of retail drug stores include the potential for retail sales in the store, the development costs of the property, and financing options such as sale-leaseback transactions. Retail sales potential is a significant driving factor for any retailer in determining the location of sites, as well as the feasible rental rates for the sites. Total retail sales for drug stores range from $470 to $804 per square foot, based on an average store size of 10,000 square feet. 8 These figures represent the four major retailers: Walgreens, CVS, Longs Drug Stores, and Rite Aid. In addition, the totals are for all stores, whether located in freestanding stores or in-line spaces in retail shopping centers. By comparison, national drug stores have median sales of $ per square foot for space located in retail shopping centers. The top 10 percent of national drug store chains occupying space in retail shopping centers have average sales of $ per square foot. 9 These statistics show that the freestanding retail stores are often able to achieve higher sales per square foot, as the overall average retail sales per square foot is higher for all locations than for only locations located in retail shopping centers. Therefore, an argument can be made that the rental rates paid for freestanding retail drug stores are driven more by the business of the occupant of the property, rather than the features of the real property. However, this is a difficult distinction to make, because the success of the retail store is largely dependent on its location, which is a feature of the real property. In addition, many other retailers, including Big Box users, base their site selection and purchase price for real estate on projections for retail sales. Development costs and financing options also influence contract rental rates for freestanding retail drug stores. The major drug store retailers compete heavily with their counterparts for ideal locations at the corners of major roads. In addition, the sites typically need to be at least an acre in size to allow for adequate parking, sufficient ingress and egress, and room for a drive-through window to pick up prescription drugs. Therefore, in the case of new sites located in developed urban or suburban areas, assemblage of multiple parcels is often required to obtain a site that is adequate in size. After assemblage of multiple parcels is complete, the demolition of existing improvements may also be necessary, which can significantly increase the development costs of the site. Due to the competition for ideal locations and the need for assemblage of parcels, drug store retailers often pay significantly higher prices for commercial land than is indicated by land sale comparables for other commercial retail uses in the area. The drug retailers often work with local developers in constructing the retail store. Then a long-term lease is created with the retail drug store company, and the property is sold to individual investors. The property may also be packaged with other freestanding drug stores built by the same company and sold in a sale-leaseback transaction. A sale-leaseback transaction is defined as a financing arrangement in which real property is sold by its owner-user, who simultaneously leases the property from the buyer for continued use. Under this arrangement, the seller receives cash from the transaction and the buyer is assured a tenant and thus a fixed return on the investment. 10 In these cases, the rental rates are often based on the development costs of the property. Each party to the sale-leaseback transaction also has a similar goal. The tenant is willing to pay a higher rental 6

5 rate for the property in exchange for the higher purchase price paid by the investor. At the same time, the investor is willing to pay a higher purchase price for the property, as long as the rental rate paid by the tenant provides an adequate return on the investor s capital. Therefore, contract rental rates that are the result of sale-leaseback transactions may likely be higher than market rents. In the case of either an individual investor or a sale-leaseback transaction, investors are attracted to the retail drug stores due to the long-term stable income created by the lease contract. Although, if the contract rental rate is determined to be above market, then the valuation of the property using the contract rent will yield a value of a leased fee interest that is higher than the value of the fee simple interest. This would violate the rule of uniformity that is important in ad valorem taxation of real property. The conclusion that the contract rental rate is above market seems to be an easy one to make given the issues discussed above, which leads to the alternative method of analyzing market rent under the scenario of market value in exchange. However, due to the substantial number of stores in markets throughout the country that have rental rates at the same levels (albeit for the same reasons); one could also conclude that the higher rental rate is indeed indicative of the overall market. When estimating exchange value, the property is considered vacant and available in the open market. In addition, a typical retail user is considered for the property rather than the specific user of a retail drug store, for which the property was originally designed. In this case, rent comparables for general users of freestanding retail space are considered. Some of the freestanding retail drug stores that have been developed and leased by the major drug retailers have not been successful store operations and have been closed. The drug store retailer is then forced to sublease the space to mitigate the losses associated with continuing to meet the obligations of the long-term lease. Discount retailers such as Family Dollar have subleased some of these spaces at rental rates that are half of the original contract rate in place and often have shorter terms than the original contract. Certainly, an income capitalization approach using this kind of market rental rate will yield a market value for the property that is significantly lower than the market value estimate of the leased fee estate based on the contract rent. However, an argument can also be made that the rental rate for the subleased space is below market, because the drug store retailer is under duress to mitigate losses on a long-term lease of a closed store. Conversely, the rental rate may be equivalent to the typical rents paid by that specific retail user, which has lower levels of retail sales on a per-square-foot basis than the drug store retailer, a consideration that is common for retail companies in determining feasible rent for their locations. The next consideration in the application of the income capitalization approach is the capitalization rate for the property, which is extracted from sales of similar properties in the market. The capitalization rate is reflective of the risk associated with receiving the cash flows on an income-producing property. Therefore, the terms of the lease contract as well as the credit worthiness of the tenant represent the primary influences in the capitalization rate. Under the scenario of a market value in use, sales of drug stores are prevalent 7

6 in the market to investors looking for long-term stable returns. The credit ratings of the tenants in place at the property provide an indication of the stability of the cash flows from the investment in real property. Among drug retailers with freestanding retail locations, Walgreens has the best credit rating with an A+ rating. CVS has a strong credit rating, as well at BBB-. Rite Aid has experienced the most financial difficulty of the major drug store retailers, which is reflected in its credit rating of B+. Capitalization rates for retail drug stores have ranged from approximately 6.5 percent to 8.5 percent over the last five years. 11 Capitalization rates increased between 1999 and 2000, but have steadily declined to the current level of approximately 6.5 percent over the last four years. Some of these capitalization rates reflect the results of sale-leaseback transactions. However, more recently, the rates are reflective of the lower risk associated with the credit tenants in place at the properties. Therefore, these capitalization rates are appropriate under the scenario of market value in use, because they reflect the capitalization rates under the assumption that the property will continue to be occupied by a drug store retailer with a good credit rating on a long-term lease. Conversely, the market value in exchange analysis considers the capitalization rate for general retail properties that are not occupied by a specific user such as a drug store. These rates may be best reflected by analyzing capitalization rates from the sales of retail strip shopping centers that have a mix of retail tenants. Capitalization rates for retail shopping centers range from 5.80 percent to 9.00 percent, with an average of 7.36 percent. 12 When applied to the lower market rental rate for properties that are occupied by general retail users rather than drug retailers, the market value in exchange decreases, further widening the gap between value in use and exchange value by the income capitalization approach. Sales Comparison Approach The application of the sales comparison approach presents similar issues as discussed in the income capitalization approach when estimating market value in use versus value in exchange for retail drug stores. An appraiser must again consider whether or not the value indicated by the sales comparison approach reflects the value of the leased fee estate or the fee simple estate when arriving at a value conclusion for ad valorem taxation. Furthermore, the appraiser must consider whether or not the value under each set of property rights is the same or different. This again is driven by the rental rate of the property compared to market. A second consideration of the sales comparison approach under the market value in use scenario is whether or not a market exists for the properties at the rental rates discussed above. Drug store properties have increased in price per square foot over the last five years from approximately $250 in 1999 to more than $332 in In addition, the major drug retailers, primarily led by Walgreens and CVS, continue to expand store locations. In addition, these retailers are showing strong financial performance with increasing same-store retail sales. 14 The demand for retail drugs also will likely increase as the baby boom generation continues to age. Therefore, the real estate market for retail drug stores will likely remain strong. Passive investors are interested in purchasing retail drug store property due to its stable income and safe re- 8

7 turns. In addition, these have become attractive properties for investors as an up leg in 1031 tax deferred exchange transactions. In a 1031 tax deferred exchange, investors can defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a property that has greater value than the one that is being sold. The investors also have a limited amount of time to complete the transaction to take advantage of the tax incentives. Therefore, investors may pay more than a market price for properties involved in this type of transaction. This combined with the arguably above market rental rates at the properties, it may indicate that the market value in use for freestanding drug stores is above market price. Therefore, the value of the leased fee estate would be greater than the value of the fee simple estate, which violates the concept of uniformity in ad valorem taxation. The exchange value of the drug stores under the sales comparison approach should consider the sale of freestanding retail stores that are occupied by retail users that are different from drug retailers. These sales would not include the incentives that drive up the sale price for retail drug stores, including the 1031 exchange incentives as well as the benefits of long term stable income from credit tenants. If the freestanding drug store was vacant and available in the open market and was purchased by general retail users or leased to these users and then purchased by investors, these transactions would provide the best indication of the market value of the property in exchange. As discussed in the income capitalization approach, the rental rates for these properties will be lower and the capitalization rates will be higher, generating a lower price per square foot than the freestanding stores occupied and leased by national drug store chains. As can be seen by the information presented, the market value in use may generate a leased fee value of the property that is greater than the fee simple value. However, a market certainly exists for the purchase of the freestanding drug stores by passive investors interested in long term stable returns. Many of these transactions occur each year. Cost Approach The cost approach is a set of procedures through which a value indication is derived for the fee simple interest in a property by estimating the current cost to construct a reproduction of (or replacement for) the existing structure, including entrepreneurial incentive, deducting depreciation from the total cost, and adding the estimated land value. Adjustments may then be made to the indicated fee simple value of the subject property to reflect the value of the property interest being appraised. 15 As previously discussed, the development costs for a freestanding retail drug store often reflect an acquisition price for the land that is significantly above market due to the need to assemble parcels and the cost of demolition that are typically necessary when ideal sites are selected and purchased in developed urban and suburban markets. In addition, the competitive nature of the drug store industry may cause land value to be further inflated if the drug retailer is competing against another national chain to gain access to the location first. As such, the actual cost of development is most reflective of the market value in use for the property, particularly if the rental rate for the property is determined based on the development costs. Under an exchange value scenario, the land value should be adjusted to reflect the amount being paid by gen- 9

8 eral retail or commercial users in the market for similar locations. Land sales for commercial properties purchased by general retail users will not likely have the premiums associated with assemblage or the competition for ideal corner locations that exist in drug store land acquisitions. In addition, under the market value in use scenario, the contract rental rate may be above market yielding a value of the leased fee interest that is greater than the value of the fee simple interest. This requires an additional adjustment in the cost approach for exchange value under economic obsolescence. The calculation of economic obsolescence is based on a capitalization of rent loss that is reflected by the difference between the contract rental rate in place and the determined market rent under exchange value. Summary The valuation issues presented under the income capitalization approach drive the issues that need to be considered in the sales comparison approach and the cost approach. The market value in use of the freestanding retail drug store is based on the contract rent in place, which is a long-term lease by a credit tenant. The corresponding capitalization rate derived from sales of these income-producing properties also reflects the price that buyers pay for the long-term income stream from a tenant with a strong credit rating. When appraising a property for the purpose of ad valorem taxation, an appraiser must determine whether or not the rental rate, the capitalization rate, and the resulting value reflect a value of the leased fee interest that is above the value of the fee simple interest of the property. Determining market rent for freestanding drug stores is a difficult proposition. On one hand, significant market evidence exists to show that the tenants that occupy the space are willing to sign long-term leases on the property. The retail sales that the drug stores can achieve at the property support the rental rates being paid, which is a common test for many retail users for the feasible rent that can be paid for retail space. However, if the property were not occupied by a retail drug store, the same rental rate would not likely be achievable in the market, indicating that the market value in use of the property indeed indicates a leased fee value that is higher than fee simple. As time passes and the properties move along the timelines of the longterm leases, it will become more and more important to analyze the contract rental rate relative to market in determining value for ad valorem taxation. This will become particularly important if the markets become overbuilt with freestanding retail drug stores. Therefore, the valuation of retail drug stores is, like any property, very location and market specific. If a store is located in a declining area or in an area that does not provide enough demand for a retail drug store, the likelihood of the store closing and being leased by a user other than a retail drug store is possible. In this case, the appropriate value for ad valorem taxation will likely fall toward the results under the exchange value scenario. However, if the property is well located without too much competition in the market, the contract rental rate may well be reflective of market, in which case the value of the leased fee estate will be equivalent to the value of the fee simple estate, supporting the concept of uniformity for ad valorem taxation. Sources 1 Deutche Bank Securities, Inc. Industry Focus, Drug Retailers, November 4,

9 2 2002, page , page , page , page , page Dollars and Cents of Shopping Centers, 2004, Urban Land Institute, page BB&T Capital Markets Equity Research, Longs Drug Stores Corporation, June 16, Dollars and Cents of Shopping Centers, 2004, Urban Land Institute page , page Marcus & Millichap Retail Research Report, 2004 Semi-Annual Report. 12 Korpacz Real Estate Investor Survey, Second Quarter 2006, PriceWaterhouseCoopers. 13 Marcus & Millichap Retail Research Report, 2004 Semi-Annual Report and Midyear Marcus & Millichap Retail Research Report, 2004 Semi-Annual Report and Midyear , page