Like other retail sectors, the drug store sector continues to consolidate. Walgreens Boots Alliance Inc. recently announced plans to acquire Rite Aid, and the $17.2 billion deal would pare the drug store sector to two national players—Walgreens and CVS. The acquisition will likely have a significant impact on the retail real estate industry, particularly the net lease sector, experts contend.

Currently, Walgreens operates roughly 8,200 stores in all 50 states and the District of Columbia. Rite Aid, meanwhile, operates nearly 4,600 stores in 31 states and the District of Columbia.

Upon completion of the merger, Rite Aid will be a wholly-owned subsidiary of Walgreens Boots Alliance, according to a statement from Walgreens. Rite Aid is expected to initially operate under its existing brand name, and “decisions will be made over time regarding the integration of the two companies, ultimately creating a fully harmonized portfolio of stores and infrastructure.”

Real estate experts are reading a lot into that simple statement. “Let’s just say that it probably isn’t going to be good news for a number of landlords out there,” says Garrick Brown, vice president of research, West, for real estate services firm Cushman & Wakefield. “Mergers like this almost always require significant consolidation of space and this one certainly won’t be any different.”

Overlapping footprints

The boards of directors of both Walgreens and Rite Aid have approved the transaction, and it is expected to close in the second half of 2016. But the deal is subject to anti-trust laws.

Consider Albertson’s acquisition of Safeway in 2014—it ran up against federal anti-trust regulations in several markets and the companies had to sell off more than 160 stores in markets where the brands overlapped.

Walgreens Boots Alliance Executive Vice Chairman and CEO Stefano Pessina describes Walgreens and Rite Aid’s footprints as “complementary,” saying that together the chains will create “an even better network.”

Real estate experts agree that the chains don’t have a huge amount of overlap. However, it’s certainly possible, if not likely, that the combined company will have to sell off some stores.

“There are definitely areas of overlap in stores,” says Brandon Duff, a net lease broker with Stan Johnson Company, a firm that focuses on the single tenant net lease industry. “New York, for example, where Walgreens has a high concentration, especially following their Duane Reade acquisition in 2010. With an estimated 13,000 retail stores combined after the merger, it is likely we would see some closing of stores where cannibalization is a threat.”

According to a statement from Walgreens, Walgreens Boots Alliance is highly focused on building a differentiated in-store experience for health, wellness and beauty, and this combination will help accelerate Rite Aid’s own efforts toward that end. Once the acquisition closes, Walgreens Boots Alliance plans to further transform Rite Aid’s stores to better meet consumer needs.

Walgreens Boots Alliance business is growing, both here and abroad. Adjusted net earnings for fiscal year 2015 increased 28.9 percent to $4.1 billion compared with the same period a year ago. Net sales in fiscal year 2015 increased 35.4 percent to $103.4 billion compared with the same period a year ago.

Previously, Walgreens announced a $1.5 billion cost transformation program through the end of fiscal year 2017, primarily in its Retail Pharmacy USA division. During the fourth quarter of fiscal 2015, the company continued to make progress with the program and achieved more than half of the program’s expected savings as of the end of the fiscal year. In the Retail Pharmacy USA division, this effort included: closing 75 stores in the quarter for a total of 84 store closings in fiscal year 2015 as part of a plan to close approximately 200 stores; reorganizing divisional and field operations; driving operating efficiencies; and streamlining information technology and other functions.

Cap rate compression

Over the past several years, most of Walgreens’ new construction has come from relocation of existing stores that were located mid-block or in multi-tenant centers to free-standing locations on hard corners, according to Randy Blankstein, president of The Boulder Group, a real estate services firm specializing in single tenant net lease properties. Rite Aid has had very limited new stores built in the last several years.

While there has been an overall decrease in new store developments, Duff says there has been no shortage of drug store product for sale in the marketplace. He points out that many investors who purchased assets two to five years ago are now disposing of properties in order to take advantage of the cap rate arbitrage. Likewise, owners who might have near term debt maturities on the horizon are also selling their properties.

In fact, The Boulder Group’s most recent Drug Store Report indicates that drug store property supply has increased drastically, by over 20 percent as owners attempt to take advantage of unprecedented high values.

When it comes to the Walgreens-Rite Aid deal, the worst case for a net lease investor would be a store closure. Even then, the tenant would still be paying rent on a dark store.

“If I owned a Rite Aid, I’d be asking myself: how long is my lease and how good is my real estate,” says one net lease broker.

The best case scenario for a net lease investor would be better credit. “Assuming Walgreens credit stood behind the Rite Aid leases going forward, this event would be a major positive for all Rite Aid owners as their store values would move substantially higher and now trade at Walgreens cap rates,” Blankstein says.

Cap rates for single tenant CVS, Rite Aid and Walgreens properties reached a new historic low in the net lease drug store sector in the third quarter 2015, according to The Boulder Group. CVS properties have the lowest cap rate at 5.45 percent, while Walgreens are trading at 5.5 percent cap rate. Rite Aid, currently not investment grade credit, is trailing at 6.63 percent.

Blankstein point out that the merger makes all the top drug store companies investment grade, which makes the whole sector more desirable. “This will likely cause transaction volume to increase,” he predicts.