Supermarket Income REIT — Visible income and growth potential

SUPR is listed on the specialist funds segment of the London Stock Exchange and 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. The long, indexed-linked leases that SUPR targets provide a high degree of visibility to contractual income streams and strong income returns for supermarket property have underpinned a long record of positive total returns, making this a relatively low-risk segment of the UK commercial property market and a bright spot in an otherwise challenged retail property sector. Given the financial strength of the leading supermarket operators, their improving financial performance and their financing strategies, they have neither the need of company voluntary arrangements (CVAs) nor, in our view, the incentive to seek to use them as a bargaining tool for lower rents. SUPR’s shareholder total return in the year to 30 June 2019 was 8.0% compared with a negative 6.0% for the wider UK REIT sector, taking total shareholder return over the two years since IPO to 16.1% (UK REIT sector: -1.0%).

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 £4.0bn of supermarket transactions over the past decade. In March 2019, it was joined by senior adviser Justin King, the former CEO of Sainsbury’s, who brings a wealth of grocery sector experience and a deep understanding of grocery property strategy.

Results for the year ended 30 June 2019 (FY19) show strong growth driven by the continued, steady build-up of the portfolio. SUPR added two new omnichannel supermarket assets during FY19, investing £96.7m (before acquisition costs) and has since acquired an eighth asset for £54.4m (before acquisition costs). The acquired assets are accretive to portfolio yield and unexpired lease term. At the end of FY19, the portfolio was externally valued at £368.2m, reflecting a yield of 4.9% and annualised passing rent of £19.2m. All the properties are let on long leases with a weighted average unexpired lease term (WAULT) of 18 years and upwards-only RPI-linked rent reviews. The acquisition of Sainsbury’s Preston in August at a net initial yield of 5.1% increases the annualised rent roll to £22.2m.

A summary of the key FY19 financials and a comparison with FY18 is shown in Exhibit 2. Rental income grew strongly, reflecting a full-year contribution from assets acquired in FY18 and a part-period contribution from the FY19 acquisitions, as well as RPI-linked rental growth. Profitability additionally benefited from economies of scale.

The key features of the FY19 financial performance are:

At the end of FY19, SUPR had debt facilities of £151.2m of which £7.2m remained undrawn. Adjusting for the year-end cash balance of £9.9m, the net drawn debt was £135.0m and the net LTV was 36.3%.

Its banking relationships have continued to broaden, with new facilities added at competitive borrowing rates that appear to reflect the underlying strength of the tenant covenants. During FY19, a £52.1m facility was agreed with Bayerische Landesbank at 1.25% above three-month Libor and hedged at an all-in fixed cost of 2.5%. Since the period end a new £47.6m facility with DekaBank has been added at a fixed rate of 1.9%. The proceeds have been utilised towards the acquisition of Sainsbury’s, Preston. The facility also includes a £40m uncommitted accordion option for the term of the facility. The three facilities, including the £100m HSBC facility in place at the beginning of FY19, are all ring fenced with significant headroom and flexibility on their financial covenants. Including the DekaBank facility, the weighted average cost of the drawn debt is 2.3% with a weighted average maturity of c four years. The vast majority of the debt is fixed rate or hedged, and over time we would expect SUPR to seek opportunities to extend the average maturity to more closely reflect the long average WAULT.

Including the post-period end acquisition of Sainsbury’s Preston and drawing the £47.6m DekaBank debt facility, the end-FY19 LTV on a pro forma basis was c 45.0%. The Company will target a LTV ratio of 30-40% in the medium term once the portfolio growth phase is complete. The SUPR board consider this conservative given the low risk nature of the portfolio

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 aimed at assets that can deliver sustainable value in a shifting retail environment. SUPR believes a portfolio value of c £1bn is a reasonable objective over the long term, or a c 10% share of its target asset pool.

In its outlook statement accompanying the FY19 results SUPR said that it continues to see numerous further growth opportunities that meet its investment objectives while potentially adding further geographical, covenant and income diversification to the portfolio. It has subsequently announced its intention to raise c £50m by way of a placing and offer for subscription of c 49.0m new shares (the ‘initial offer’) as part of a broader placing programme of up to 200m shares. The initial issue is at 102p per share which represents a discount of 5.1% to the closing price immediately prior to the announcement and a premium to the end-FY19 NAV per share of 97p. The company has identified three assets (the ‘target assets’) with an aggregate value of c £140m which meet its investment criteria. The target assets all benefit from long RPI-linked leases, with a weighted average lease term of 15 years. They are all occupied by Sainsbury’s, providing strong rental security, and benefit from low site cover, and geographical locations which would support multiple sales channels including online, and click and collect delivery, in addition to in-store customers.

The investment adviser has entered into exclusivity arrangements with the owners of one of the target assets and is in advanced discussions with the owners of the other two. In addition to the target assets, the company has identified a strong investment pipeline of a further four assets and has begun preliminary due diligence on those assets.

Both the initial issue and the placing programme are subject to shareholder approval at an EGM expected to be held on 1 October 2019 and a prospectus is available on the company’s website (www.supermarketincomereit.com). If approved by shareholders the placing & offer is expected to close on 2 October 2019.

SUPR believes that the £50m target issue size for the initial issue when combined with debt resources should provide sufficient resources to acquire two of the target assets and that the larger pipeline will help to ensure negotiating flexibility in determining pricing with vendors. If less than the £50m target is raised, the company expects to be selective, determining which assets to pursue from the broader pipeline. If investor demand exceeds £50m, SUPR may increase the size of the initial issue up to the maximum of 200 million new ordinary shares provided for in the placing programme.

In growing its portfolio since IPO, SUPR has been able to rapidly deploy capital and mitigate cash drag. Equity proceeds have been invested within four weeks on average and have been fully leveraged within six weeks.

During FY19 and already in FY20 (with the completed £54.4m acquisition of Sainsbury’s, Preston) the SUPR portfolio continued to grow and diversify by geography and tenant (see Exhibit 6).

The eight omnichannel supermarket properties that comprise the current portfolio operate both as physical stores and online fulfilment centres. Excluding Sainsbury’s, Preston, the external portfolio valuation of £368.2m at end-FY19 compares with the combined purchase price (before acquisition costs) of £351.4m. The £16.8m uplift in value is equivalent to 4.8% of the aggregate purchase price and reflects the improving covenant strength of the operators as tenants, favourable supply and demand characteristics in the investment market, and the investment manager’s ability to source off-market acquisitions.

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:

To better illustrate the potential impact of contractual RPI rent uplifts on rental income growth, SUPR has provided the data in Exhibit 5, which assumes an annual RPI increase of 3.2% applied to the end-FY19 portfolio annualised rents with allowance made for the completed acquisition of Sainsbury’s, Preston in the June 2020 total. Obviously the rate of RPI may differ from the 3.2% assumed, but we believe this to be a reasonable assumption by which to illustrate the impact and is consistent with recent experience. In practice, there is a ceiling to the earnings benefit represented by the rent review caps on uplifts, of up to 5%.

With the illustrated growth in rents, the yield on property purchase values also increases. However, if the external property valuation were to continue to reflect an unchanged yield these higher illustrated rents would also indicate higher property values, with a positive impact on NAV. Other factors may affect property valuations and NAV but we estimate that applying an unchanged 4.9% valuation yield to the illustrative FY24 rental income shown in Exhibit 6 would add c £70m to the portfolio valuation, or c 30p per share based on the end-FY19 number of shares in issue.

The investment adviser believes that there is currently an attractive opportunity for investors to gain exposure to supermarket property. This view is based on the observation that in contrast to many asset prices, including those in the wider real estate sector, supermarket property yields have remained relatively stable over the last few years, while supermarket operators appear to be entering a period of operational and financial recovery, which should improve their covenant strength as tenants. The investment adviser points to the ongoing decoupling of supermarket property prices from supermarket operator corporate bonds which, while a different asset class share similar covenant risk but a lower return profile.

Supermarket property has historically been priced at investment yields below the UK all-property sector and reached a low of 4.3% in 2007. However, in around 2013 the market dynamics changed and supermarket property experienced a negative yield shift against the broader property trend. Since 2015, supermarket yields have been above the all-property sector average. At the same time, the distribution warehouse subsector has witnessed a significant compression in yields.

The period of yield widening for supermarket property 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 12.5% over the next five years, from £194bn in 2019 to £218bn in 2024. Although the new discounters, led by Aldi and Lidl, have grown strongly and taken market share, the share gains have mainly been at the expense of the existing discounters. Tesco, Asda, Sainsbury’s and Morrisons (the ‘big four’) retain a combined market share of c 68%, with multi-billion-pound revenues and established brands. The investment adviser believes their ability to protect market share is in part due to the underlying nature of their store portfolios, which also underpins their online strategies. As incumbents, they tend to have the largest sites in some of the best locations, around which they have built a network of omnichannel stores, combining traditional supermarkets (still the dominant channel by far, and growing) with online (with a c 6% share but the fastest-growing channel). As it targets a sustainable and growing income stream, SUPR only invests in omnichannel stores, which the investment adviser estimates account for 74% of all online grocery fulfilment.

Although competition among operators remains high, the grocery sector appears to be entering a period of increased stability. In June 2019, Moody’s Investors Service upgraded Tesco (two-thirds of SUPR’s passing rent) to investment grade following a similar move by Fitch in late 2018. The improving strength of tenant covenants has not been mirrored in supermarket investment yields, as the following chart demonstrates.

The 7–10% 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. If the relationship between the share price and the NAV per share is stable, EPRA NAV total return and shareholder total return (share price change plus dividends) will be the same. In fact, since IPO SUPR has seen an increase in P/NAV, to a current c 1.1x such that shareholder total return has exceeded NAV total return. Shareholder return was 8.0% in the year to end-FY19, following 8.1% in the 13 months to end-FY18. The increase in P/NAV partly reflects investor appetite for companies that offer secure, long duration, visible income growth, but we also believe the operational progress and growth that SUPR has delivered. At the same time, reported NAV total return has been negatively affected by property acquisition costs that must inevitably be incurred in building the portfolio. Excluding these, the underlying NAV total return was much stronger and in line with SUPR’s targets (Exhibit 10).

SUPR is one of a group of companies in the broad property sector that focuses on income returns derived from long leases. As can be seen in Exhibit 11, this group of companies has outperformed the broader property sector as well as the FTSE All-Share Index over the past 12 months, which we attribute to the continuing search for yield by investors and a recognition that within the property sector, income returns have historically been a less volatile component of overall returns than capital returns. SUPR’s 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. For comparison purposes, Exhibit 11 is calculated using last reported EPRA NAV per share and trailing 12-month DPS declared. On this basis, SUPR has an above average yield while its P/NAV is slightly below the average.