Supermarket Income REIT — Strong progress in H120

Supermarket Income REIT (SUPR), which is listed on the special funds segment of the London Stock Exchange, invests in a diversified portfolio of supermarket property, let to leading UK supermarket operators on long, RPI-linked leases. The investment objective is to provide an attractive level of income, with the potential for capital growth and a 7–10% pa total shareholder return target over the medium term. Aggregate shareholder total returns since IPO in July 2017 until 31 December 2019 were 24%.

Supermarket property has a long record of positive total returns underpinned by stable income returns in part due to the long length of lease commitments, upwards only rent reviews and a strong occupier covenant. SUPR invests in omnichannel stores, which it believes are the future model of grocery retail in the UK. These omnichannel stores operate both as physical supermarkets and as online fulfilment centres and as a result perform a critical role in the business strategies of the tenant operators.

The company has an independent board of non-executive directors and has appointed Atrato Capital as investment adviser. The Atrato management team brings a very high level of experience and knowledge of the UK real estate sector, having advised on, structured and executed more than £4.5bn of supermarket transactions (including c £500m for SUPR) over the past decade.

The six months ended 31 December 2019 (H120) was another busy period for the company and the financial results showed strong growth in all metrics reflecting the continuing growth of the portfolio. Two additional omnichannel supermarkets were acquired during the period for £114.8m (before acquisition costs). The acquisitions added £6.4m to contracted rental income, reflected in a blended net initial yield of 5.2%, above the existing portfolio average. The portfolio now consists of nine supermarkets let on fully repairing and insuring leases, with upwards only, RPI-linked rent reviews.

With the company tracking further extensive acquisition opportunities, £100m in additional equity was raised in October 2019 and a new £76.6m five-year debt facility was added, attractively priced at a fixed 1.9%. The equity issue, at a 5% premium to the end-FY19 NAV, was well received and was oversubscribed despite being upsized from the initial £50m target.

The period also saw a new strategic partnership agreed between the investment adviser and EVO Energy, a leading UK renewable energy company, aimed at evaluating and executing projects that will reduce the environmental impact of the portfolio. In this respect, terms were agreed with Tesco for a solar rooftop installation at the Thetford store, the first of several planned across the portfolio.

Since reporting the interim results, SUPR has acquired a tenth supermarket store for £34.0m (excluding acquisition costs) reflecting a net initial yield of 5.5% or 6.3% including an adjoining Homebase store. It has also confirmed that in partnership with a large institutional investor it is in discussions to acquire a minority stake in a portfolio of 26 supermarkets let to Sainsbury’s. The company notes that there is no certainty as to whether the acquisition will be agreed, nor the terms on which such a transaction may take place. Both of these developments are discussed further below.

The key financial highlights of the H120 results were:

Exhibit 5 shows SUPR’s portfolio in more detail, including the stores in Preston, Lancashire, and Cheltenham, Gloucestershire, acquired during H120 and the Hessle store subsequently acquired. The key to income growth visibility is the selection of properties with RPI-linked rental uplifts and let on long unexpired lease terms to institutional grade tenants, although this is reinforced by a highly selective investment strategy that additionally focuses on:

The growing portfolio is becoming increasingly diversified by asset and by geographic location. The properties are currently let to Tesco (48%), Sainsbury’s (41%) and Morrisons (11%), all good quality covenants. Tesco’s and Morrisons’ corporate debt is rated investment grade and Sainsbury’s has a target to achieve this by 2022.

The prominent 13-acre site acquired for £34.0m (excluding acquisition costs) comprises a 50,000 sq ft supermarket store with 12-pump petrol filling station and nearly 600 car parking spaces, as well as an adjoining Homebase store with a net sales area of 21,000 sq ft.

The supermarket store is let to Sainsbury’s, which has a long history of trading from the site, has been acquired with an unexpired lease term of 14 years with annual, upwards-only, RPI-linked rent reviews (subject to a cap and floor). It has purpose-built online fulfilment docks and supports Sainsbury’s online fulfilment for the surrounding area. The supermarket passing rent is c £2.0m pa, which represents an attractive net initial yield of 5.5% on the site without attaching any value at all to the Homebase store.

The Homebase store has an unexpired lease term of four years and generates c £0.3m pa in passing rent. Sainsbury’s has guaranteed this rent for the duration of the lease. Consequently, the combined total net initial yield on the purchase is 6.3% for the next three years, with good asset management potential thereafter.

The acquisition was funded by drawing on available revolving credit facilities.

The H120 acquisitions were financed from the proceeds of the October 2019 share placing (£100m gross) and drawings from the new bank facility arranged during the period. The new £76.6m five-year debt facility with Deka Bank arranged in August 2019 carries a low fixed interest rate of 1.9%, broadened the company’s banking relationships and extended average maturity.

SUPR now has £228.7m of debt facilities comprising a £100m revolving credit facility (RCF) with HSBC, and a five-year interest only loan with Bayerische Landesbank in addition to the new Deka Bank facility. Undrawn facilities at the end of H120 were £60.5m and following the Hessle acquisition £25m remains available to fund continuing investment.

Additionally, SUPR is in discussion with several potential lenders on refinancing and upsizing the £100m HSBC RCF on substantially the same terms but increasing the duration to five to seven years. The effect of this would be to increase the weighted average debt duration to between four to six years (currently a little over three years) and provide significant financial flexibility to support future growth.

SUPR has negotiated significant headroom on its debt covenants with a maximum 60% LTV and minimum 200% interest cover ratio compared with 32.4% and 615%, respectively, in H120.

The investment adviser estimates that from a pool of c £20bn of supermarket properties that are not owned directly by operators, c £10bn meet SUPR’s strict selection criteria and that a portfolio value of c £1bn is a reasonable objective over the long term, or a c 10% share of its target asset pool. Investor interest in supermarket property has increased competition for assets, but the company says that it continues to closely track an extensive pipeline of potential longer-term opportunities.

SUPR confirmed the discussions regarding the possibility of it taking a minority stake in a portfolio of 26 supermarkets let to Sainsbury’s in response to press comment. The press reports have suggested that SUPR may enter a joint venture with a view to purchasing British Land’s 26% stake in the portfolio, which could be worth £105m. The portfolio is fully geared through a securitisation with the portfolio income being used to service and pay down debt. Lease expiry and debt repayment should occur in 2023 and ahead of that we would expect the leases to be renewed or assets sold. Should the transaction go ahead, it would enable SUPR to benefit from a potential lease renewal or gain access to a valuable pipeline of assets which we believe share similar characteristics to its current portfolio.

The newly formed strategic sustainability partnership between the investment manager, Atrato, and EVO Energy will evaluate, execute and manage a range of projects across the portfolio aimed at reducing carbon emissions. This will provide support for SUPR’s environment, social and corporate governance (ESG) policy and will be in step with similar policies adopted by the operator tenants, including their efforts to reach carbon neutrality by 2050. The company has agreed terms with Tesco for the installation of a 370 kilowatt rooftop solar array at the Thetford store, which will provide c 310k kw per hour of carbon free electricity. The required investment will improve the environmental sustainability of the site while also generating an additional incremental income stream and enhancing the long-term capital value of the site. The company hopes to install similar decarbonised energy producing plant across the estate over the medium term, representing an investment of c £3–5m.

To better illustrate the potential impact of contractual RPI rent uplifts on rental income growth, SUPR has provided the data in Exhibit 7, which assumes an annual RPI change of 2.5%. Obviously RPI may differ from this level, but we believe this to be a reasonable assumption and consistent with current experience.

With the illustrated growth in rents, the yield on property purchase values also increases. However, if we assume no change in property valuation yields, the external market valuations of the properties would be expected to increase further. We estimate that applying an unchanged 5.0% yield to the illustrated FY24 rental income would add c £65m to the portfolio valuation at that point, or c 29p per share. As we discuss below, the investment manager continues to believe there is a strong potential for yields to tighten to below current levels.

In addition to the potential for property valuations to increase with rental growth at unchanged yields, the investment adviser highlights the scope for supermarket property yields to reduce, relative to other classes of commercial property potentially in absolute terms, which would have a positive effect on supermarket property valuations.

Supermarket property has historically been priced at yields below the UK all-property sector; however, this has not been the case since c 2015 (see Exhibit 8). Supermarket property yields have increased in recent years, even as the broader UK commercial property market and the distribution warehouse subsector have seen yields decline. The period of yield widening for supermarket property obviously corresponds to a period of intense competition among the supermarket operators, against a background of continuing growth in online retail and its transformational impact on traditional retail distribution. However, unlike some of the pressures being felt elsewhere in the retail sector, UK consumer spending on grocery products has grown each year since 1999 and is forecast by IGD Retail Analysis to grow by a further 12% over the next five years, from £194bn in 2019 to £217bn in 2024. Online sales (currently around 6% of the total) are expected to take an increasing share, but the majority (74%) of online grocery orders are fulfilled from within supermarkets rather than from dedicated online fulfilment centres, with the major operators operating a network of omnichannel stores, combining traditional supermarkets (still the dominant channel by far, and growing) with online (the fastest-growing channel). Given the capex required, dedicated online-only facilities are viable only in areas of high population density and the big four operators continue to leverage their store networks to support last mile logistics for online grocery. The resultant growth in e-commerce sales in such locations does not appear to be fully reflected in the investment market and valuations as evidenced by the widened gap between supermarket and distribution warehouse yields. Viewed alongside the decoupling of supermarket yields from corporate bonds despite the financial strength of the tenant operators, as well as the maturity of the overall commercial property and economic growth cycles, the investment manager continues to believe that the investment prospects for the supermarket operators remain favourable.

Investor interest in the supermarket property sector picked up sharply in 2019 with investment volumes increasing c 70% to £1.8bn (source: Colliers). A number of institutional investors stepped up their activity in the sector, most notably Realty Income, which entered the UK market and accounted for 30% of the supermarket property volume, including the acquisition of 12 stores let to Sainsbury’s. SUPR accounted for c 9% of the total volume while remaining disciplined in its strict asset selection and financial targets.

The 7–10% NAV total return targeted by SUPR is the product of rental income increasing with RPI, supporting dividend growth and, to the extent that property valuation yields do not change, NAV growth. Targeted returns also assume a benefit from gearing, which the company expects to be in the 30–40% range over the medium term and once the portfolio growth phase moderates.

SUPR has performed strong since IPO, deploying capital resources swiftly to reduce cash drag, acquiring well-performing assets, and benefiting from increased scale and diversification. Total shareholder return (the change in share price plus dividends paid) was 7% in H120, taking the cumulative total to 24% since IPO (dividends paid added back but not reinvested). With the shares re-rating to a c 10% premium to NAV, total shareholder return is ahead of total accounting return (the change in NAV per share plus dividends paid but not reinvested) since IPO, although the difference is more than accounted for by acquisition costs written off during the period as SUPR has built its portfolio (Exhibit 10).

Based on consensus forecasts (Exhibit 11), SUPR shares trade on a prospective FY20 yield of 5.4% and a P/NAV of 1.1x. Consensus expectations point to growth of both DPS and NAV per share in FY21.

In Exhibit 12 we show a comparison of SUPR with a group of other property companies that focus on income returns derived from long leases. Taken as a whole, the group trades at a P/NAV premium to the broad UK property market (which we estimate to have a P/NAV of c 0.9x on a trailing basis), which we believe primarily reflects a higher yield and a focus on stable long-term income. Compared to this narrow peer group, SUPR has a higher yield and lower P/NAV ratio. Its average unexpired lease term of 18 years is above the average for this group and its RPI-linked rent growth provides investors with considerable visibility of income with protection against inflation. We note the potential, discussed above, for yield tightening in the supermarket sector to lift NAV.