Supermarket Income REIT — Funded for identified further growth

This note provides an update on our outlook note published in March 2022, providing a detailed review of SUPR’s strategy and prospects.

The offer that closed on 26 April 2022 resulted in £300m (gross) being raised by the issue of 247.9m new shares under SUPR’s existing placing programme and an additional £6.7m from the issue of 5.6m shares in a PrimaryBid offering, specifically targeting retail investors. As a result, the number of shares in issue increased by 253.5m or nearly 26%. The issue price of 121p represented a 7.1% premium to the 31 December 2021 (end-H122) EPRA NTA per share of 113p and a discount of 4.3% to the 126.5p share price immediately before the offer was announced. Of the 450m shares authorised under the placing programme that expires in October 2022, 22.6m remain available for issue.

The proceeds of the equity raise have initially been used to reduce outstanding drawn debt, but we expect these will be deployed during FY23 to fund acquisitions. The debt refinancing, announced on 4 July 2022, represents SUPR’s first unsecured financing and provides additional, more flexible debt funding and enhances the overall average debt average maturity1. It has been made possible by the increased scale and diversification of SUPR’s portfolio, the strong fundamentals of the sector and SUPR’s recently awarded Investment Grade credit rating. The proceeds of a new unsecured £412.1m unsecured credit facility with a syndicate of banks2 will be used in part to refinance £294m of existing secured commitments (of which £255m will be retired), providing £157m of additional debt capital. The new unsecured facility has a margin of 1.5% over SONIA and a weighted average term of six years (inclusive of uncommitted extension options). It consists of three tranches:

Through its investment adviser (Atrato Capital) SUPR has built a strong record of swift capital deployment. This has been achieved by identifying a range of suitable assets ahead of capital raising, primarily off-market and at an advanced stage of due diligence or under exclusivity. By having a range of opportunities, its bargaining position is protected, and swift deployment has usually followed.

Ahead of the April 2022 equity issue, SUPR’s provided details of a strong pipeline of investment opportunities. As is normal, we would not expect its actual investment to completely match this pipeline, but it does provide confidence in the company’s ability to deploy its available capital in a timely fashion. The April pipeline comprised:

Following previous capital raises, SUPR has generally been able to deploy equity proceeds within three months and achieve full deployment, including associated debt capital, within six months. In the current rising interest rate environment, it is important that the company remains disciplined in its investment decision making to generate positive return for shareholders. Although this could cause a slight delay, we expect currently available capital to be deployed into £500m of acquisitions before the end of 2022 (by end-H123).

The acquisitions of the Chineham Shopping Park in Basingstoke, anchored to a top trading3 Tesco superstore, and an Asda supermarket in Carcroft, Doncaster, announced on 4 July 2022 for a combined £82.9m (before costs), are SUPR’s first since closing the equity raise in late April. The purchase prices reflect a combined net initial yield of 4.9%.

The omnichannel Tesco superstore on the Chineham site has a c 61k sq ft net sales area and operates as an online hub, supporting 13 home delivery vans and a dedicated click and collect facility in the car park. The site also includes an M&S Foodhall, an Iceland store and other complementary non-food tenants, collectively generating strong footfall. It has been acquired with a remaining lease term of 12 years and is subject to five-yearly open-market rent reviews.

The Ada supermarket at Carcroft, with a net sales area of c 46k sq ft is also an omnichannel store, supporting local online fulfilment through click and collect. The property has been acquired from Asda, which has operated on the site since the 1970s with the store being fully refurbished in 2019, under a sale and leaseback transaction. The new, 100-year lease is subject to five-yearly upwards-only rent reviews linked to CPI (capped at 2.5% with a floor at 0.0%).

During H122, SUPR acquired eight supermarket assets for an aggregate £243m (before acquisition costs) at an accretive net initial yield of 4.5% and average 16-year WAULT.

Ahead of the April equity raise, during H222 SUPR has announced the acquisitions of a further three supermarkets with a weighted average net initial yield of 4.8% and WAULT of 19 years for a total consideration of £128.3m (before acquisition costs). These comprise:

Included in the acquisitions above were two non-food, quick service restaurant units for a combined £2.5m (before acquisition costs).

The strong development of SUPR’s direct portfolio can be seen in Exhibit 1. By end-FY22, prior to the Chineham and Carcroft acquisitions, the direct investment portfolio comprised 41 stores with a valuation that we expect to be more than £1.5bn.

Inflation-linked rental uplifts apply to 85% (76% RPI and 9% CPI) of passing rent.4 Although indexed rent uplifts are capped at an average c 4%, below the current level of inflation, SUPR nonetheless benefits from strong visibility of income growth, at a rate that maintains the affordability of rents for operators and compared with open market rent levels. Given the non-discretionary nature of most grocery sales, supermarkets have historically benefited from an inflationary environment, with their ability to mitigate supply chain cost pressures through price increases. We expect this to continue to be the case. Although it appears that operators are currently experiencing some margin pressures as grocery prices increase, including the effects of consumers ‘trading down’ to lower-cost alternatives and in some cases reducing the ‘volume’ of their shopping baskets, there are offsets such as eating more at home. Operator cash flow remains strong and rents affordable. The investment adviser estimates that store rents typically represent a relatively low share of store turnover and that market rent levels tend to track store turnover over the medium term. It estimates the average rent to turnover ratio across the portfolio is c 4%,5 which it believes indicates that rents remain highly affordable and while grocery inflation outstrips rent caps, this affordability should improve further.

SUPR has a relatively high share of variable rate debt, the cost of which has risen noticeably in recent weeks. At end-H122, 44% of drawn debt was fixed/hedged (‘the hedge ratio’).6 SUPR’s hedging strategy, designed to mitigate the impact of significant increases in interest rates, targets a hedge ratio of 60% or more and we believe that the company had anticipated using the increased borrowing flexibility arising from its recent Investment Grade credit rating7 to increase this towards its target, including the introduction of fixed-rate, long-term, unsecured bond funding or private placements.8 SUPR considers that the strong rise in interest rates has for now significantly reduced the attractiveness of fixing or hedging the cost of more of its debt but, understandably, is watching market developments closely. Implied market expectations are that the benchmark SONIA rate will moderate in the coming months.

The refinancing announced on 4 July 2022, at a 1.5% margin over SONIA, has a positive impact on SUPR’s average portfolio margin but this is more than outweighed by the upwards move in SONIA. Based on the current level and structure of borrowings we expect the hedge ratio to have increased to c 50% although based on total debt facilities rather than drawn debt facilities, we expect the hedge ratio to be slightly lower than previously. Including amortisation of loan arrangement fees, the weighted average finance cost was c 2.5% pa at end-H122 compared with the running interest cost of c 1.9% pa. Given the subsequent increase in market interest rates, we estimate the current running cost of interest to have increased to c 3.0%, with a total average finance cost of c 3.5%.

Based on a loan to ratio (LTV) of 40%, the equity yield of c 5.0%, the average cost of debt and adviser fees at a marginal rate of 0.65% of NAV, we estimate a ‘break-even’ acquisition yield of 4.8%. Based on our assumed acquisition yield of 5.0%, and despite the recent increase in market interest rates, this continues to provide a margin for SUPR to grow without diluting dividend cover. We forecast net assets to rise above £1.5bn by FY24 where the marginal management fee drops to 0.45% from the current 0.65%.

We would not expect SUPR to benchmark every transaction strictly against the ‘break-even’ level as its investment strategy seeks to balance risks and returns across the portfolio, seeking a spread of counterparties, assets and lease terms. While long leases provide income visibility, shorter leases may provide enhanced returns, blending a higher immediate yield with asset management opportunities to regear (extend) the lease. On a limited number scale, we would expect SUPR to acquire additional assets subject to open market rent reviews where the investment case is strong.

Since SUPR listed in July 2017, acquisition yields for supermarket assets have steadily compressed (store prices have risen), largely driven by strong investment demand for the secure income that supermarket assets provide, with those that have inflation-linked or fixed-uplift rents (as opposed to those with rents reviewed on an open market basis) providing good visibility of income growth. This yield compression has been reflected in the valuation of SUPR’s portfolio assets and in its NAV. Given the high degree of correlation between inflation and food prices and the level of investor appetite in the sector, SUPR expects continuing growth in both supermarket rents and for this to be reflected in capital values. This is particularly the case for omnichannel stores, the focus of SUPR’s investment, where their positive outlook is yet to be fully differentiated in market-wide valuations.

Importantly, despite yield compression, SUPR sees further potential for accretive acquisition-led growth using what it believes to be its information and relationship advantage. This may give it an insight into store trading and help it to identify those stores that are strategically important to the operators, supporting its ability to source attractive stores from the very large volume of market transactions. Although not expected, should global economic and pollical challenges become reflected in higher yields, while this would affect asset valuations,9 it would increase the income return on acquisitions.

Over the past three years,10 there have been c £5bn of transactions in the UK supermarket sector. In addition to SUPR, significant investors such as Realty Income, a large US REIT, have been active in the market, while Tesco has also been active in repurchasing assets as an alternative to leasing. Exhibit 2, produced by SUPR, tracks whole of market transaction yields in respect of its target market (more than 10 years remaining lease length with fixed or index-linked rent uplifts). Acquisition yields for these assets have compressed from c 5–6% at the time of SUPR’s IPO to c 4.4%.11 This is below the 4.7% net initial yield of SUPR’s portfolio, which the company believes reflects a conservative approach by valuers.

The April 2022 equity raise and the sharp rise in interest rates are the main drivers of our forecast changes. The number of shares in issue has increased by 26% and, on a geared basis, the c £300m of additional equity capital supports a c £500m increase in assumed acquisitions, before reinvestment of the JV proceeds. The increase in market interest rates has increased our forecast for annualised total finance expense (including amortisation of loan arrangement fees) to a peak of c 4.0% by end FY23, subsequently declining to c 3.6% by end-FY25 compared with our last published c 2.9%. Our forecasts for running interest costs (before amortisation of loan arrangement fees) are based on market expectations reflected in the three-month compounded SONIA forward curve. The implied increase in the UK base rate by at least 1.5% from the current 1.25% may prove pessimistic if uplifts are constrained by consideration of the impacts on the economy and living standards.

In addition, the continued increase in inflation has a positive effect on underlying index-linked rental income, partly offset by administrative cost increases.

In addition to the already announced forecasts referred to above, we assume:

Our other key assumptions include:

With recurring earnings distributed in dividends, the strong growth in SUPR’s portfolio since IPO has been financed by a blend of new equity and debt, while targeting a medium-term LTV of 30–40%. We expect it to operate towards the top of this range, reflecting the increased scale and diversification of the portfolio and the robust financial position of tenants. It can also anticipate with some confidence significant cash proceeds from the JV in mid-2023.

Following the refinancing announced on 4 July 2022, SUPR has total committed debt facilities of £862m, up from £705m (c £794m including accordion options12) previously. We estimate drawn debt of a little under £400m at end-FY22, including short-term debt repayments from the proceeds of the April equity raise, ahead of deployment, and a net LTV of around 18%. By end-FY23 we expect most of the increased debt facilities will have been drawn to fund acquisitions and that the LTV will increase towards 40% on a fully deployed basis.13 We forecast that additional debt of c £125m will be required in FY24 as the cash returns from the JV are reinvested on a geared basis.

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.

SUPR has performed strongly since IPO, consistently deploying capital resources swiftly to reduce cash drag, acquiring well-performing assets and benefiting from increased scale and diversification. Total accounting return (the change in NAV plus dividends paid) has steadily increased, reaching 12.1% in FY21 and 7.8% in the first half of FY22. The cumulative total return since IPO to end-H122 is 41.6% (dividends paid added back but not reinvested) or a compound 8.1% pa. Returns would be higher if adjusted for the c 6.0p per share of acquisition costs incurred in building the portfolio since IPO. Dividends have been increased each year and represent two-thirds of the total return since IPO. Although we expect DPS growth to slow while the rise in borrowing costs is absorbed, our revised forecasts continue to indicate returns in line with the company’s target range. By FY25 we expect returns at the top-end of the target range as scale builds further and assuming no acquisition costs in the year nor any further compression of valuation yields.

Based on the company’s FY22 target aggregate DPS of 5.94p, the prospective yield is 5.0%. The share price premium to end-H122 EPRA NTA per share of 113p is 5%.

In Exhibit 6 we show a comparison of SUPR with a group of other property companies that focus on income returns derived from long leases. SUPR’s share price has outperformed peers, the UK commercial property sector and the broad UK equity market over the past one and three years. Compared with the group average, SUPR has a similar yield and higher P/NAV ratio (5% premium versus the peer average 5% discount). Its predominantly RPI-linked rent growth provides investors with considerable visibility of income with protection against inflation, while the strength of its tenant covenant has been successfully tested and even enhanced during the pandemic. We expect it to prove resilient in the inflationary conditions, supporting income and capital values.