Supermarket Income REIT — The next stage of growth

SUPR’s investment proposition is based primarily on robust and visible income growth from long (c 13 years weighted average lease length) upward-only, mostly inflation-linked leases with strong tenants. The UK grocery market is experiencing strong growth and, 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.

Since listing in 2017, SUPR has built a £1.8bn portfolio, through a disciplined acquisition strategy, focused on its chosen omnichannel market segment. After a recent pause in growth, reflecting financial and economic uncertainty, it made clear with its H124 results that it viewed market conditions as once again favourable for it to deploy its strong balance sheet for the ‘next stage of growth’. In particular, it cited increasingly attractive investment yields, the market expectation that interest rates will soon fall, and the positive impact of grocery sales growth on store rental values. It has since invested c £35m (before costs) in the UK and c £64m (before costs) in a portfolio of 17 stores operated by Carrefour in France, its first investment outside of the UK. If it were to increase LTV back towards the higher end of its 30–40% medium-term range, it would have additional available debt capacity of up to c £100m.

In late April, SUPR acquired a portfolio of 17 omnichannel supermarkets in a sale and leaseback transaction with Carrefour, the second largest grocery retailer France, with a global presence in 30 countries across Europe, Asia and South America, and annual turnover of more than €90bn (c £80bn). The transaction is immediately accretive to earnings, with a wider yield spread over funding costs than would be available in the UK for comparable assets let to a similarly strong covenant and is a continuation of SUPR’s strategy of investing in ‘the future model of grocery’.

The Carrefour stores operate under the ‘Carrefour Market’ brand.6 SUPR says they have a long history of successful trading and form a key part of Carrefour’s ‘Drive’ online grocery fulfilment network in their local catchment areas. They are geographically spread in France, with a weighting to the norther parts, and the stores have an average gross internal area of c 40,000 sq ft, which is towards the upper end of the size range for the Carrefour Market format.

The portfolio was acquired for €75.3m (c £65m), before acquisition costs, which represents a net initial yield of 6.3%. Store rents are reviewed annually and are inflation-linked without caps. The weighted average lease term is 12 years (with a tenant-only break option in year 10).

SUPR has initially drawn €81.7m (c £70m) from its existing revolving credit facility with HSBC, at a margin of 1.7% over Euribor, the European benchmark bank lending rate, which is currently c 3.7%. The transaction generates an accretive positive spread from day one, which SUPR expects to lock in with longer dated borrowings at a similar rate or better. This positive spread will further increase with rental growth.

Supermarket property yields continued to widen in 2023, including a further increase in Q423, in common with the broader UK commercial property market. MSCI data as at end-H124 indicate an average 6.4% net initial yield for the supermarket property sector as a whole, although this broad group includes weaker performing stores and stores let to some of the weaker tenant covenants. SUPR’s tighter average portfolio yield of 5.8% reflects its portfolio weighting to strong trading Tesco and Sainsbury’s stores. Both the sector yield and the SUPR portfolio yield are well ahead of the 5.1% broad property market yield, as well as the 4.7% yield for logistics assets. Logistics assets continue to be viewed positively by investors, not least for their exposure to structural growth trends in online purchasing and the positive outlook for rental growth.

In seeking to deploy capital, SUPR is not simply targeting opportunities where the acquisition yields are accretive to earnings, but also intends to maintain the covenant strength of its portfolio, and this selectivity narrows its available options. Although supermarket yields have generally widened, investor demand, for the better assets and stronger covenants in particular, has remained strong. In stark contrast to the broad commercial property market, 2023 was a record year for supermarket property transactions. These amounted to £2.1bn, with operator sale and leaseback activity accounting for more than half, including one large £650m transaction undertaken by Asda.

In current market conditions, SUPR sees the most attractive opportunities in acquiring good-quality, ‘overrented’ stores, let to strong covenant operators (such as Tesco or Sainsbury’s), with relatively shorter lease terms, and the potential to create value through lease regears. Stores that are perceived by many investors to be overrented generally trade at a discount to those that are considered to have rents in line with ‘the market level’. SUPR believes that considerable value can be created if the regear risks can be accurately assessed and the expected cash flows correctly modelled. The value created by regear opportunities comprises a period of higher ‘overrent’ for the term of the existing lease, followed by reversion to a lower, rebased level of rent over a newly extended term, with the increased duration of cash flow providing potential for a capital uplift. Successful underwriting includes an ability to accurately assess the strength of the tenant and its ability to pay the overrent until lease maturity, as well as the likely level of the regeared rent, for which the rent to turnover ratio (RTO) and not rent per sq ft is the key metric as explained below. Supermarket operators are understandably willing to pay higher rents for stronger performing stores. As a sector specialist, the investment adviser expects to be able to underwrite the regear risks more effectively than many others by leveraging its market information advantage and expects acquisition yields of 7% or more.

We would classify the recent £34.7m (before costs) acquisition of a Tesco store in Stoke-on-Trent as just such a regear opportunity. The store sits on an 8.7 acre site and comprises an omnichannel supermarket and petrol filling station. It was built in 1994 and supports Tesco’s online fulfilment operation via both home delivery vans and customer click & collect. Rents are reviewed annually, linked to RPI (subject to a 4% cap and a 0% floor), and the purchase price reflected an attractive yield of 7.5%. We estimate rental income of c £2.8m pa.

The store has a c 55k sq ft net sales area, but the rent is based on the larger gross area of c 78k sq ft. The rent also includes (is ‘grossed up for’) additional amounts payable, commonly related to fixtures and fittings provided by the landlord or to on-site petrol filling stations. SUPR says that for many properties, the headline total rent has been grossed by around 12.5%. Such adjustments apply to the Stoke-on-Trent store, for which SUPR indicates a rent of c £30 per sq ft, which is above the portfolio average of £23 per sq ft. Although we do not know the RTO in respect of the store, it does appear that there is a degree of over-renting, for which the 7.5% net initial yield and 11-year remaining lease term provides a very attractive compensation. SUPR says that the yield for an equivalent asset, let at a market rent level, with a longer 15-year lease, would likely be c 5.25%. Moreover, the Stoke-on-Trent store is well-performing and strategically attractive to the tenant, both of which will be reflected in future lease negotiations.

While in many cases UK supermarkets are overrented, SUPR has an affordable portfolio average rent to turnover ratio (RTO) of 3.8% (see below). Some of its stores have a lower-than-average RTO and some higher, often reflecting targeted regear opportunities. For the overrented stores, let to strong tenants, SUPR is in the ‘harvesting’ stage, collecting above ‘market rents’ until maturity. The portfolio weighted average unexpired lease term (WAULT) at end-H124 was 13 years, and there is no significant maturity until 2029. This lease maturity profile, the balance between under-rented and over-rented stores, and continuing strong UK grocery growth all indicate that there is no ‘cliff edge’ were portfolio rents to ‘gap down’ and punctuate organic rental growth or dividend paying capacity.

Supermarket leases are typically long term (25 years or more at inception), with rent reviews that are predominantly inflation linked but may also be ‘open market’ or subject to fixed uplifts. Most (78%) of SUPR’s contracted rents are indexed to inflation, 71% to the Retail Prices Index (RPI) and 7% to the Consumer Prices Index (CPI). Of the balance, fixed uplifts account for 2% and open market reviews 20% (c 12% of supermarket rents). Most of SUPR’s open market rents relate to its complementary co-located, non-food assets, providing mostly non-discretionary items.

In the market, many index-linked leases were created in operator sale and leaseback transactions in the 1990s and 2000s, enabling large operators such as Tesco and Sainsbury’s to expand their estates while recycling capital into further growth. On the expectation that store turnover would broadly track inflation, index-linked leases (with caps and collars) were the norm, with initial rents generally set at c 4% of turnover, or around two weeks of trading. This 4% RTO level is important as, according to SUPR, it continues to be widely used by operators as the point around which to set an affordable starting rent.

During the COVID-19 pandemic, grocery sales were boosted by more people working from home, much of which has stuck. Recent inflation has significantly outpaced capped index-linked rent uplifts, reducing the RTO. Both of these factors have made supermarket rents increasingly affordable. However, this follows a period when the reverse was true, with store sales lagging rents and the RTO increasing. The move of electrical appliances and other non-food items out of the stores to online delivery was one factor. For grocery sales this is not the case as the vast majority of online sales are fulfilled through omnichannel stores. Having fallen back from the pandemic peak, online sales are again growing ahead of the total market. Market share gains by the fast-expanding discounters also had an impact on store growth for the larger operators, although it appears this may be coming to an end.

While many stores across the sector may have become overrented, it is a complex matter to identify which stores and by how much by focusing on rent per square foot, and this is why SUPR and the operators focus on RTO. While some property consultants and index providers such as MSCI publish rent per square foot data (for MSCI this is around £20 per sq ft), SUPR believes these are very likely to underestimate how much operators are willing to pay to secure the ongoing occupancy of strong trading stores. The reasons for this include:

SUPR says that it has seen many examples of operators being willing to commit to new 15-year lease terms on existing stores, provided the new rent is reset to their acceptable RTO level, with the resultant implied rent per square foot being of lesser importance.

Although inflation is expected to moderate over the forecast period and will slow annual inflation-indexed rent uplifts, it will take some time for recent high levels to be fully reflected in five-yearly reviews. Meanwhile, SUPR expects an acceleration in open market rent reviews, all on a five-year cycle.

Taking this together, our forecasts reflect like-for-like growth in passing rent of 3.5% in FY24, 3.0% in FY25 and 2.0% in FY26.

We have included the Stoke-on-Trent asset and the Carrefour portfolio acquisition only. An additional c £100m of deployment would take our forecast LTV to c 39%, towards the higher end of SUPR’s targeted range. Assuming a medium-term financing cost of c 5.5% and a 7.0% acquisition yield, this would add an additional c £1.5m, or about 0.1p per share, of adjusted earnings to our forecasts, on an annualised basis.

We assume no change in the H124 net initial yield throughout the forecast period, such that rental growth feeds fully through to portfolio valuation uplifts and growth in NAV.

Given the level of economic and financial market uncertainty, early in 2023 (H223) SUPR took active measures to reduce interest rate risk and used part of the proceeds from the sale of its interest in the Sainsbury’s Reversion Portfolio (SRP) to repay debt.

Having fully hedged its floating rate debt during FY23, 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 for 2.7 years (from end-H124) to first maturity (before extensions) at an average 3.1%.

At end-H124, total debt facilities amounted to £689m or £764m including accordion options at the discretion of the lender. £588m of debt had been drawn, with £177m available (including the accordion options). The first maturity, in August 2024, is the £97m Deka Bank facility, more than covered by undrawn facilities. Shortly after the release of the H124 results, SUPR increased its unsecured facilities with Sumitomo Mitsui Banking Corporation by £37.5m to £104.5m. The additional tranche is priced at a margin of 1.55% (1.40% on the original tranche), fully hedged for the full term to September 2026. Subsequently, SUPR increased its revolving credit facility with HSBC to £75m from £50m, with an unchanged margin of 1.7%. Most of the facility was drawn, in euros, to fund the Carrefour acquisition, at the margin plus Euribor. Neither of these recent facility extensions is reflected in the maturity profiles below, which are based on the H124 disclosure.

The percentage of unsecured borrowing is 60%, providing significant financing flexibility. The end-H124 LTV of 33% was well within the company’s medium-term target range of 30–40% and, following the subsequent acquisitions, the pro-forma LTV is 37%. There is strong headroom on banking covenants including a maximum LTV of 60% and minimum interest cover ratio of 1.8x. At end-FY24, SUPR’s interest cover was 5.8x. As of end-H124, property values would need to fall by c 42% before breaching the LTV covenant and net rental income would need to fall by 56% before breaching the interest cover covenant. In February 2023, Fitch Ratings reaffirmed SUPR’s BBB+ investment-grade credit rating.

At the same time as the September 2023 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 cap starting in August 2024 and terminating in July 2025 with a strike rate of 1.4%, representing the maximum SONIA rate payable.

The 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 5.

The FY24 target DPS of 6.06p represents a yield of 8.2%, while the shares trade at a 16% discount to H124 NAV.

Compared with a selected group of other property companies that focus on income returns derived from long leases, SUPR’s share price performance is slightly below peers over the past one and three years and, over the same period, the peer group has underperformed the wider property sector and the UK equity market. Calculated on a trailing basis for consistency, the yield on SUPR shares is well ahead of the peer group average and SUPR trades at a higher P/NAV.

The H124 results for the six months to 31 December 2023 were reported in March. Adjusted earnings presented no material surprises. Property valuations, which are less predictable and outside of the company’s control, declined, reducing NAV.

Passing rent has continued to increase, by £4.7m in the period, and by £6.6m over 12 months. During H124, SUPR exercised its right to purchase two stores that had formed part of the SRP, for £36.4m, reflecting a net initial yield of 6.5%, well ahead of the 4.3% net initial yield on which the majority of the SRP stores had been sold to Sainsbury’s. Also, during H124, the average annualised uplift of 3.6% on rent reviews concluded added £1.6m to passing rent.

The subsequent acquisition of Tesco Stoke-on-Trent and the Carrefour portfolio have since added an additional c £7.2m to passing rent.

Although the recent increase in passing rent did not fully contribute in H124, the growth in net rental income earned in the period, and in the past 12 months, has substantially offset the loss of income from SUPR’s disposal of its interest in the SRP. The effect of this was spread across both H223 and H124 but will have no further impact in H224. With the SRP disposal proceeds partly used to repay borrowings, interest has reduced, and admin costs have been well controlled.

Compared with end-FY23, the H124 portfolio value was 1.1% lower, or 3.2% on a like-for-like basis. Rental growth had a positive £29m impact on valuation, but this was more than offset by the £83m negative impact from yield widening. The like-for-like reduction in property values was slightly less than the 4.0% capital decline that MSCI data show for the broad UK commercial property market over the same period.

With adjusted earnings and dividends paid in balance, the property valuation decline drove the change in EPRA NTA/NAV per share.

Exhibit 13 summarises SUPR’s H124 financial performance, commencing with adjusted EPRA earnings before providing a reconciliation to IFRS.

With respect to adjusted EPRA earnings, we highlight the following, with comparisons to H123 unless specified otherwise:

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