Supermarket Income REIT — Progressive dividend policy remains in place

Given the non-discretionary nature of most grocery sales, accounting for c 14% of household spending,1 inflation drives revenue growth. Although SUPR does not benefit directly from this growth (its rents are not tied to store turnover), it underpins the visibility and sustainability of its income growth, capital values and sustainable long-term returns.

The sustainability and visibility of supermarket income has historically offered relative stability and superior risk-adjusted returns compared with the broad UK commercial property market. We expect this will continue. Supermarket lease agreements are often long-dated (typically 20–30 years at inception without break options), fully repairing and insuring, and subject to upwards-only rent review, often linked to inflation. The large operators represent strong covenants. In times of inflation, operators have the ability to significantly pass through cost pressures on non-discretionary grocery sales and while the recent high level of price increases (grocery inflation peaked at c 19% but has since moderated) has seen operator margins tighten, cash flows have remained strong.

Supermarket property values have not been immune to the market-wide impact of higher capital costs although the 13.7% like-for-like decline in SUPR’s property valuation in FY23 compared favourably with the c 19% decline in capital values across the wider market and stabilised in H223.

With fundamental support for the sector, and property yields that are c 100bp (1%) higher than the broad market average, transaction volumes have remained robust, a mix of operator buybacks and investment flows.

SUPR’s balance sheet position is both strong and flexible, debt has been reduced and interest costs fixed. A key development during FY23 was the sale of SUPR’s 51% beneficial interest in the SRP for £430.9m (before costs). Following full receipt of the proceeds, and a significant post year-end refinancing programme, borrowing has been reduced by c £100m since end-H123 and the pro-forma loan to value ratio (LTV) to 34%. Debt costs are fixed at 3.1% for the more than four-year average duration of borrowings, 61% of which is now unsecured.

The details of SUPR’s highly successful investment in the SRP are contained in our January update note. The SRP was created by Sainsbury’s in sale and leaseback transactions in 2000, comprising 26 stores, which it continued to operate under occupational leases, which expired in March 2023 and July 2023.

Following investments in 2020 (£102m before costs) and 2021 (£115m before costs), through a 50:50 joint venture with British Airways Pension Fund (BAPTL), SUPR took a 25.5% (its share) indirect beneficial interest in the SRP. In January 2023, it acquired BAPTL’s 25.5% beneficial interest. This additional stake was acquired for £196m, a c £4m discount to net asset value. It was funded by a short-term financing facility, which was fully repaid from the sale proceeds, and the discount to NAV offset £4m of loan arrangement fees. Similarly, the additional income of £2m that SUPR earned on the increased stake offset the loan interest. Crucially, the transaction allowed SUPR to unlock an additional £16m of fair value through the efficient unwind of the structure.

Including recurring income and the profit on disposal of £19.9m reported in FY23, SUPR’s investment generated highly attractive returns for the company and, including income earned, the disposal reflected a money multiple of 1.9x and an internal rate of return of c 30%.

The £430.9m sale proceeds were received in tranches. The first tranche of £279.3m was received in March 2023 and a second tranche of £116.9m was received immediately after the FY23 year-end. The third and final tranche of £34.7m was conditional on the sale of the remaining five stores in the SRP.7 Four of these stores were acquired by SUPR (exercising its purchase option) for £61.6m in March 2023 and, post year-end, in July 2023, utilising £33.3m of the outstanding receivable.8

On a recurring EPRA basis, the circa nine-month FY23 contribution of SRP investment, prior to sale, was £11.7m. The sale of the 21 stores to Sainsbury’s was at an average net initial yield of 4.3%, significantly tighter than the yields achieved by SUPR on acquisitions, with this positive income arbitrage highlighting the company’s ability to efficiently recycle capital.

We forecast organic rental growth, improved cost efficiency and fixed borrowing costs to deliver continued, albeit modest, dividend growth, fully covered by adjusted earnings, discussed in detail throughout this report.

FY23 adjusted EPRA earnings (see Exhibit 2) were slightly (2%) below our forecasts due to a combination of lower rental income and higher costs, partly offset by higher expenses and associate/JV earnings.

There is no material change in our forecasts for FY24 adjusted EPRA earnings and a c 2% increase for FY25. We now expect DPS to increase marginally (c 1%) in both years and to be fully covered. For FY26 we forecast further earnings progress, driven by rental uplifts, with continuing modest, fully covered DPS growth.

FY24 rental income will benefit fully from the H223 acquisitions and from the two transactions completed in July. Given the high cost of capital relative to investment yields we have assumed no further acquisitions, although the company is open to accretive capital recycling. On this basis, our forecasts for FY25 and FY26 rental income are driven entirely by rental uplifts at review.

Our finance cost forecast is adjusted for the refinancing completed in early H124 and slightly higher average borrowings related to the acquisitions lift our expected finance costs.

We expect additional costs related to the SRP unwind to fall away in FY24, but allowing for this, our forecast costs are higher than previously assumed. We nonetheless expect cost efficiency to continue to improve, with the EPRA cost ratio falling towards 13% by end-FY26 (FY23: 15.5% excluding direct vacancy costs).

With adjusted EPRA earnings fully distributed, we forecast modest c 2% pa growth in EPRA NTA/NAV per share, assuming that the positive impact of rental growth on property values is dampened by some additional yield widening.

We discuss each of these key forecasting assumptions in the following sections.

Annualised contracted rents9 increased by £23.1m or 28% to £103m during FY23, substantially driven by acquisitions, which added £20.7m, and rent reviews. A total of nine stores were purchased during the year, including two of the four stores acquired from the SRP portfolio. The acquisition of the other two SRP stores, in July, added an additional £2.5m to contracted rents. The combined consideration for all of these stores was £399m, reflecting an average net initial yield of 5.5%, well ahead of the average 4.3% yield on the 21 SRP stores acquired by Sainsbury’s. On an earned basis, gross rental income of £95.8m in FY23 is yet to fully reflect this growth.

Most (78%) of contracted rents are indexed to inflation, 71% to RPI and 7% to CPI. Of the balance, fixed uplifts account for 2% and open market reviews 20% (c 12% of supermarket rents). Of the total, 56% are reviewed annually and c 43% periodically, nearly all five-yearly and one lease seven-yearly. Uplifts in indexed leases are typically capped at an average of c 4%.

The 15 annual indexed rent reviews completed in FY23, some benefiting from higher than average cap level, generated a blended uplift of 4.1%. Reflecting accumulated inflation uplifts, the two five-yearly reviews were completed at an average 17% uplift, equivalent to 3.4% pa. Like-for-like growth in total portfolio rents was 2.7%.10

UK inflation began to pick up from early 2021, with the 12-month rate peaking in October 2022. From end-2020 to October 2022, RPI increased from 1.2% pa to 14.2% pa and CPI from 1.8% pa to 11.1% pa. Although mostly capped at around 4% for each year, five-year reviews being settled currently are yet to capture the full impact and will increasingly do so even if the current annual rate of inflation continues to moderate in line with the general expectation.

The investment adviser notes that market rental values are typically driven by store turnover, with an average c 4% rent/turnover ratio across the sector. With turnover significantly inflated by inflation it expects market rents, and open market rent reviews, to accelerate.

Our forecasts assume that annual CPI inflation falls to c 3% by end 2024 and to a constant c 2% by end-FY25. We assume that RPI remains at a typical c 1% premium to CPI.

Lease reviews in respect of the ancillary assets (6% of rent roll) are all on a five-yearly basis at varying dates, primarily (96% by rent roll) on an open market basis.

Based on this mix of lease terms, we assume portfolio like-for-like rental income growth of 3.5% pa through FY24–26.

Significant financing activity in FY23 saw SUPR extend and broaden its banking relationships and increase the hedging of its floating rate debt exposure to 100%.11 A further comprehensive debt refinancing in September 2023 extended the weighted average maturity to just over four years (including extension options, or around three years to first maturity). The hedging arrangements were similarly adjusted to maintain a fully fixed/hedged position to maturity at an average 3.1%.

The refinancing introduced a new lender, Sumitomo Mitsui Banking Corporation (SMBC), with a £67m three-year term loan, attractively priced at a margin of 1.4% over SONIA. Partly drawn facilities with HSBC were reduced from £150m to £50m with outstanding balances repaid, and an undrawn £77.5m facility with Barclays/RBC was cancelled. Total committed facilities now amount to £689m, of which, including post balance sheet events, £585m has been drawn,12 down from £672m at end-FY23.

The percentage of unsecured borrowing is now 61% of the total (FY22: 48%), providing significant financing flexibility. The pro-forma group level LTV of 34% compares with an average 60% covenant limit on the secured borrowing and property valuations would need to fall by more than 40% to test this. Group level interest cover of 4.1x13 compares with 1.8x minimum required. In February 2023, Fitch Ratings reaffirmed SUPR’s BBB+ investment grade credit rating.

At the same time as the refinancing, SUPR used the value of its existing in-the-money interest rate hedges to extend the term of its hedging arrangements, matching the maturity (before extensions) of its extended debt facilities, at no additional premium. The existing hedges were adjusted along with a new forward starting cap starting in August 2024 and terminating in July 2025 with a strike rate of 1.4%, representing the maximum SONIA rate payable. The weighted average interest cost of borrowing (including margin) over the period to maturity was increased marginally, to 3.1% from 2.9%.

The newly adjusted hedging arrangements are on a stepped basis, with the blended average cap rate increasing through the period to maturity. Advantageously, this better matches the income profile, which will similarly increase with rental growth. Based on the 1.4% strike price of the forward starting cap, we estimate that the 3.1% average cost to maturity implies a c 0.5% uplift each year from end-FY25, and a similar step-down for FY24.

A summary of our forecast interest costs, based on this assumption, are shown in Exhibit 11. In addition to the step-up in the SONIA cap rate, we also assume a refinancing of the low-cost Deka facility (fixed 1.90%) at maturity into other existing facilities. Facilities reaching maturity during FY25 and FY26 are assumed to be refinanced at 5%. This is somewhat below the level currently implied by the forward SONIA curve (c 4.25% by end-FY25), before lending margin, but recognises the financing provided by the strong balance sheet position.

Following the sharp market-wide adjustment of commercial property values to rising bond yields and increased economic uncertainty that affected SUPR in H123, stability returned in H2.

Over the year, SUPR’s portfolio valuation reflected a 13.7% like-for-like decline, with the valuation yield widening to 5.6% from 4.6% at end-FY22 (and 5.5% at H123). Compared with the c 19% decline in capital values across the wider market this was nonetheless a relatively robust performance.

With financial markets remaining volatile since June 2023, there has been a growing perception that while inflation is moderating and interest rates are approaching a peak, both may settle at levels above previous expectations. A higher than previously anticipated medium-term cost of capital continues to be reflected in broad market property valuations, which have weakened further since June, albeit moderately.

In this context, our forecasts reflect an increase in SUPR’s valuation yield of c 35 basis points (0.35%) by end-FY26. Each 10-basis point (0.1%) change in this yield assumption is equivalent to a c 2p per share change in forecast NTA per share. Despite the implied uplift in the valuation yield, we still expect property values to increase, driven by expected rental growth.

Irrespective of uncertain market conditions, there are other positive factors that should continue to support supermarket values.

Attracted by the secure income that the sector provides, investment demand for supermarket property has remained robust, in contrast to the wider UK commercial property market. Total supermarket investment volume of c £1.7bn in the year to June 2023 compared with £1.6bn in the year to June 2022. Broader market volumes in H123 are down more than 50% year-on-year. The supermarket investment volumes include store repurchases by Tesco and Sainsbury’s (including its c £1bn repurchase of 21 of the 26 SRP stores) as they utilise strong cash flow. During the year to June 2023, among a broad range of other investment buyers, SUPR maintained a circa one-third share of the investment market (excluding operator repurchases).

Reinforcing investor interest, supermarket yields are at an increased premium to the broad commercial property market and the logistics sector, having historically traded at a discount. The discount reversed in around 2015, corresponding with a period of intense competition among the supermarket operators, including growth in the discounters. The big four operators (Tesco, Sainsbury’s, Asda and Morrisons) and have nonetheless maintained a combined 65% share of the grocery market, largely unchanged in recent years, successfully operating a strategy of price and assortment through a multi-channel brand-focused offering. Each is a multi-billion-pound revenue company, operating in a growing market, with an established brand, and supermarket locations across the UK. Although trading margins have come under pressure recently with customers shielded from the worst of price rises, they have been consistently profitable and continue to generate strong cash flow.

As its name suggests, SUPR is focused on providing a secure and attractive level of income, with the potential for capital growth. Since listing in June 2017, the company has progressively increased dividends, and this has been the driver of total return. Since achieving scale, SUPR has targeted DPS to be fully covered and although it fell very slightly short in FY23, due to higher interest rates and a cautious capital deployment policy, it expects this to be the case in FY24.

Aggregate NAV/accounting total return since listing has been 30.1% or an average 4.5% pa. Dividends paid represent more than 100% of the total, or an average 5.1% pa. In the period to end FY22, prior to the impact of significant market-wide property valuation weakness as interest rates climbed, the accounting total return was 8.1% pa.

We forecast increasing returns in the FY24–26 period, continuing to be driven by dividends, enhanced by a modest capital uplift.

The FY24 target DPS of 6.06p represents a yield of c 7.5%, well above the 5.4% average since listing in June 2017. Meanwhile, the shares trade at a c 13% discount to FY23 NAV.

In Exhibit 19, we show a comparison of SUPR with a group of other property companies that focus on income returns derived from long leases. Over the past year, feeding through to the three-year performance, SUPR’s share price has trailed the peer group average, while the peer group average is slightly below the broad UK property sector over one year but in-line over three years. Calculated on a trailing basis for consistency, the yield on SUPR shares is well ahead of the peer group average. Similarly, it trades at a higher P/NAV.

It is interesting to contrast the share price performance of SUPR with that of the leading supermarket operators, Tesco and Sainsbury’s, its leading tenants. Since the beginning of 2021, ahead of the sharp rise in inflation and interest rates, the weighted average of the share prices of these two operators has increased by c 30% versus the broad market increase of c 12% and a c 20% decline in the price of SUPR shares. While rising interest rates have negatively affected the cost of, and return on, capital for SUPR, and weakened property values and NAV, the strong growth of supermarket sales has enhanced the security and visibility the company’s long-term rental growth.

Exhibit 21 summarises the SUPR’s FY23 financial performance, commencing with adjusted EPRA earnings before providing a reconciliation to IFRS. Acquisitions, rental uplifts and an improved cost ratio drove strong earnings growth, despite the increased cost of borrowing. However, on a per share basis, adjusted earnings was slightly lower, reflecting a 27% increase in the average number of shares (resulting from capital raised in H222), additionally affected by a slower, highly selective approach to acquisitions in shifting market conditions.

We highlight the following:

Included with IFRS earnings but not in adjusted EPRA earnings were:

SUPR’s portfolio has grown very strongly since listing (Exhibit 22). Including the two assets acquired since end-FY23 it is valued at just over £1.7bn, with annualised passing rent of £103.0m reflected in a net initial yield of 5.6%. The portfolio comprises 55 supermarket stores, 93% of which are omnichannel, and a small number of co-located ancillary assets, typically non-grocery stores, the balance (see below).

SUPR is highly selective in the supermarkets it acquires, not simply targeting omnichannel stores but seeking to ensure that its portfolio as a whole is focused on index-linked longer leases for the income visibility they provide, combined with strong sustainability credentials. SUPR’s stores will typically have the following additional attributes:

Whilst the weighted average lease term (WAULT) of the portfolio is 13 years there is a wide range of maturities, with the longest individual term to expiry c 99 years and the shortest around two years. Shorter leases can enhance the overall return by blending a typically higher immediate yield with asset management opportunities to regear (extend) the lease. SUPR will also acquire assets subject to open market rent reviews where the investment case is strong. With supermarket rent levels typically benchmarked against store turnover, the high level of inflation is likely to have a more immediate impact on open market rents.

With growth, the portfolio has become increasingly diversified by store operator as well as by geography, although it continues to be focused on the main operators, Tesco and Sainsbury’s. This partly reflects their market presence (Tesco has a grocery market share of c 27% and Sainsbury’s c 15%) combined with leading positions in omnichannel delivery, but also the strength of covenant that these operators provide.

The ancillary assets are not specifically targeted by SUPR but have been acquired alongside a small number of the supermarket acquisitions. With a strong focus on essential non-grocery retail, they can often attract shoppers to the site and enhance overall footfall. Primarily, they provide SUPR with access to attractive supermarkets while allowing it to maintain full strategic control over sites, while also providing asset management options. The valuation reflects a net initial yield of 8%, while the leases are all subject to five-yearly reviews and mostly on an open market basis.

Full details of the portfolio are available on SUPR’s website.

SUPR's ESG strategy is currently very focused on the sustainability agenda, which benefits from a close alignment of the aims of both SUPR and its tenants, who continually invest to improve the environmental credentials of the stores they operate. Tenants have set various targets to achieve net zero carbon from 2040 or earlier, resulting in good engagement with SUPR on sustainability initiatives that are beneficial for both. These include the installation of energy efficient lighting and refrigeration, solar photovoltaic panels and electric charging points. A benefit of the supermarket operator sustainability commitments coupled with long-dated, fully repairing and insuring leases is that much of the cost of investing in modernising and decarbonising stores is undertaken by tenants at their own expense. To support these efforts, SUPR is now receiving energy consumption data from c 85% of tenants and hopes to increase this further, including the greater access to data written into ‘green’ lease provisions that it seeks to include in all new leases.

SUPR is targeting that all its supermarkets will be rated EPC C or better by 2028 and B or better by 2030. Currently 84% of SUPR’s portfolio has an EPC14 rating of C or better.

Supermarket Income REIT (SUPR) is listed on the Premium Segment of the London Stock Exchange15 and is a constituent of the UK 250 and UK EPRA NAREIT indices. The company has an independent board, comprised of six non-executive directors, chaired by Nick Hewson, and has appointed Atrato Capital as investment adviser. Full details of the company’s leadership team can be found on the SUPR website.

Atrato Capital (‘Atrato’) is part of Atrato Group, a market leading investment and advisory group established in 2016. The Atrato Group is additionally active in a range of long income strategies including supported housing and clean energy generation, where it is investment adviser to LSE-listed Atrato Onsite Energy.

Atrato’s supermarkets team brings a very high level of experience and knowledge of the UK sector, having advised on, structured and executed more than £5.0bn of supermarket transactions (including more than £1.7bn for SUPR). Justin King, widely recognised as one of the UK’s most successful grocery sector leaders, works as a senior adviser to Atrato. He brings a wealth of experience in the grocery sector and a deep understanding of grocery property strategy. He served as chief executive of J Sainsbury for 10 years until 2014, and before that was part of the leadership team at Marks & Spencer and previously held senior roles at Asda.

SUPR benefits from a competitive fee structure, calculated according to a tiered structure that has allowed shareholders to benefit more fully from the company’s growth. The marginal fee rate is 0.65% of NAV. There is no performance fee and 25% of the investment advisory fee is paid in shares.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. On a relative basis, markets generally expect supermarket property to be less volatile than broader property markets given the defensive nature of the underlying grocery sector. We consider the main sensitivities to include: