Supermarket Income REIT — Fully hedged debt protects indexed rent growth

This note provides an update to our March outlook note, which covers SUPR’s strategy, historical performance and opportunities within the supermarket property sector in greater detail. We focus on the implications for SUPR and its tenants from the sharp increase in inflation and interest rates, as well as the recent FY22 results and subsequent developments.

During FY22, IFRS rental income increased c 50% to £72.1m, driven by acquisitions and mostly inflation-linked rent uplifts. On a like-for-like basis, rents grew by 3.7%. EPRA earnings increased by 56% to £57.4m or 5.9p per share (FY21: 5.6p). DPS of 5.94p (+1.4%) was 1.08x covered by EPRA earnings1 and the FY23 DPS target was increased by 1% to 6.0p. Including net property gains of £52.9m (both from the direct portfolio and SUPR’s share of JV gains), IFRS net earnings were £110.3m. For the direct portfolio, like-for-like valuations increased in line with rental growth. EPRA NTA per share increased 7% to 115p and, including DPS paid, the EPRA NTA total return was 12.5%.

The FY22 rental income did not fully capture the impact of acquisitions during the year and since. Since the beginning of FY22, SUPR has completed two oversubscribed equity placing programmes, raising c £507m (gross) and has deployed c £682m to acquire 18 additional assets, at a blended net initial yield of 4.9%, adding scale and diversification. It has grown to be the largest UK landlord of omnichannel supermarket stores and its directly owned portfolio now comprises 50 supermarkets, valued at c £1.8bn, with annualised contracted rent of c £96m reflecting a net initial yield of 4.6%. The weighted average lease term to expiry is c 15 years. Indirectly, the company has an economic interest in 26 supermarkets comprising the Sainsbury’s Reversion Portfolio. Following the agreed acquisition by Sainsbury’s of 21 of the stores, SUPR expects its value to reach c £190m, a c 1.7x multiple on purchase price. The prospect of cash returns from around the middle of 2023 provides significant flexibility in balance sheet and investment strategy.

With c 81% of the directly owned portfolio benefiting from upward-only, index-linked rent reviews (subject to floors and caps), SUPR provides significant inflation protection. However, since the latter part of FY22, rising interest rates have had a negative impact on borrowing costs. Around 60% of the cost of end-FY22 drawn borrowings was fixed or hedged, but after that date the company took the decision to fix all its interest rate exposure through a new swap arrangement. As at 21 September 2022 (the reporting date for the FY22 results), 100% of drawn debt was fixed/hedged, at a blended interest cost of c 2.6%.2 The cost of acquiring the hedges was £35.2m, representing a c 2.8p reduction in EPRA NTA per share, to be reflected in the H123 balance sheet.

Although the cost of capital has increased across the sector, investment demand has, until recently, remained strong, supported by the visible long-term cash flow that the sector provides. Transaction activity has reduced but there are no clear signs that vendors are yet to meaningfully adjust their price expectations. As a result, we assume no further acquisitions3 and that the c £190m cash returns from the JV are used to repay borrowings. However, if interest rates decline through 2024, as implied by market expectations and/or acquisition yields widen sufficiently, the acquisition of operationally and strategically attractive assets is a possibility. SUPR’s own cost of capital should benefit from the FY22 migration of its shares to the premium segment of the Main Market of the London Stock Exchange, followed by inclusion in the UK 250 and EPRA Nareit indices, and the award of an Investment Grade credit rating.

Given the non-discretionary nature of most grocery sales, supermarket operators have demonstrated an ability to mitigate input cost pressures through price increases, a necessary inevitability of the tight margins at which they operate within a highly competitive retail market. Annual UK grocery inflation reached 12.4% in September.4 While operator margins have tightened, rent costs account for only a small proportion of store revenues, for the SUPR portfolio c 4%. Meanwhile, sector cash flows remain strong, and the large operators continue to represent very strong lease covenants. Upwards only, index-linked rent uplifts are typically capped rents at c 4%, a level at which, in the current inflationary environment, the company continues to benefit from visible income growth while rents become more affordable to operators, and the potential for stores to become ‘over-rented’ is diminished.

Within the grocery market, in-store sales retain the largest share of sales, but the trend towards online sales (click and collect and home delivery) continues. Over the last three years (spanning the period before and after lockdowns), online grocery sales are up 73% and market share has increased from 9% to 12%, with a peak at 15% during the lockdown. The £10bn increase in online sales value materially exceeded that of the UK discounter distribution channel.5 Within the online delivery channel, omnichannel (combining in store and online fulfilment) has continued to increase share, now accounting for more than 80% of all online orders. SUPR is in the strong position of focusing on both the largest market segment (in store) and the fastest growing (omnichannel). While SUPR does not benefit directly from this, it underwrites the attractiveness and longevity of its stores to operators and asset values. That said, with a portfolio net initial yield of 4.6%, there is no obvious sign that SUPR has fully benefited from this, a potential defensive characteristic if yields do widen across the market. More generally, supermarket property has historically offered relative stability compared with the broad UK commercial property market, and current market average net initial yields of c 4.5% are above the IPD All Property yield of 4.0%.

Our revised forecasts reflect no material change in underlying operational performance. Rental income is materially reduced by lower assumed acquisitions than previously, but the EPRA earnings impact in FY22 is offset (more than offset in FY23 and slightly in FY24) by lower borrowings and a reduced running cost of debt. The average running cost of SUPR’s drawn borrowing is now fixed/hedged at a lower level than we previously expected despite market rates having increased. The further increase in interest rates forecast by the market6 will have no impact on SUPR or our forecasts.

As was similarly reflected in our previous forecasts, the falling away of the JV contribution in FY24 is a drag on reported EPRA earnings and we have pegged DPS at the FY22 level of 6.0p to maintain a high level of dividend cover. The £35.2m cost of hedging has transferred some of the impact of higher interest rates to the balance sheet, reducing EPRA NTA per share in FY23, with our expectation that property values will not keep pace with indexed rental growth also having a negative impact. The latter is reflected in a c 35bp yield widening over the forecast period.

SUPR’s total debt facilities are c £862m and we forecast that c £690m of this has been drawn (including funding for the £84m Bradley Stoke acquisition), giving SUPR significant funding headroom. However, undrawn, unhedged floating rate debt is priced at a c 1.5–2.0% margin (depending on the facility) over the SONIA market reference rate and, if this develops in line with consensus expectations, the spread between marginal borrowing costs and typical current acquisition yields will become negative. While this persists, we expect SUPR to take a highly selective approach to acquisitions, and it seems reasonable for us to assume none. Over time, it seems likely that asset yields will widen and borrowing costs decline. Moreover, SUPR has a record of being able to source operationally strong assets at attractive prices, including where it has identified value-add opportunities (eg through lease regears). Its strong liquidity position and ability to transact quickly may prove advantageous in negotiations with vendors. In addition to available debt facilities, we forecast an LTV of c 25% through to FY25, well below SUPR’s medium-term target of 25–30% target on a fully invested basis.

While opportunities for near-term portfolio growth are substantially dependent on the evolution of market conditions, we note that in addition to being a highly successful investment, the JV cash receipts provide significant flexibility in the management of SUPR’s balance sheet and acquisition strategy.

Since end-FY22, SUPR has agreed the purchase price for the 21 (of 26) stores in its JV portfolio (discussed in detail in our March outlook note and summarised in the footnote below),7 which Sainsbury’s had earlier exercised its option to acquire. Including the agreement of new leases on four of the remaining stores, SUPR estimates that the eventual value of its investment in the JV will reach c £190m8 (a 1.7x return on the purchase cost). The purchase by Sainsbury’s is expected to complete between March and July 2023, resulting in cash distributions to SUPR.

SUPR’s investment case for its participation in the JV was based on its assessment of the quality of the portfolio9 and its expectation that, as a result, Sainsbury’s would remain committed to many of the stores. The investment has been highly successful, generating annualised returns above SUPR’s 8–10% target range from a combination of asset revaluation and the running yield on the portfolio.

SUPR’s medium-term target of a 7–10% pa return is the product of rental growth, supporting dividend growth and, to the extent that property valuation yields do not change, is capitalised into asset value and NAV growth, with the additional benefit of gearing.

The accounting total return (change in NAV adjusted for dividends paid) has been consistently positive since the company listed in July 2017, averaging 8.1% pa and within the target range. Dividends per share have increased each year and represent c 60% of the total return. Annualised returns have steadily increased over the period, benefiting from swift deployment of capital resources, acquiring well-performing assets, and increased scale and diversification.

We expect the sharp rise in inflation and market interest rates, increasing the cost of capital, to have a negative impact on returns in the short term but for these to remain positive, despite reduced gearing, particularly in FY24 and FY25. FY23 returns will be held back by the costs of interest rate hedging and our expectation that property yields will widen (a drag on property valuations). Although we have assumed no growth in DPS paid in the period we expect it to be the driver of an average annual accounting return of 5.7% for the three years FY23 to FY25.

Across the commercial property sector, income returns have historically shown less volatility than capital values, which have displayed material swings. Supermarket property returns have historically been less volatile than mainstream sectors, reflecting predictable cash flows from strong tenant covenants based on the non-discretionary nature of most grocery sales. With government bond yields significantly higher than at the start of the year,10 there is a widespread expectation that the widening of property valuation yields (decrease in values) that is already apparent across much of the UK commercial property sector will spread. Our forecasts allow for a c 0.35% widening of the valuation yield on SUPR’s portfolio and, in this context, we expect a relatively modest NAV per share progression despite like-for-like rental growth.

The end-FY22 EPRA ‘topped-up’ net initial yield of the SUPR portfolio was 4.6%. In addition to the yield widening reflected in our forecasts, we estimate that a 10-basis point increase/decrease in yield would decrease/increase FY22e NAV per share by c 3.1p.

In this section we provide an overview of the FY22 results and subsequent events that have further increased annualised rental income, enhanced debt facilities, fixed debt costs and crystalised additional value within SUPR’s JV.

During FY22, SUPR raised £506.7m (gross) in two oversubscribed equity placing programmes and acquired 12 supermarket assets with an aggregate purchase price of £381.0m (before costs). Portfolio value increased by £423m to £1.57bn, including 3.7% like-for-like growth, and reflected a blended net initial yield (NIY) of 4.6%. Acquisitions and asset management maintained the weighted average unexpired lease term at 15 years. The period-end annualised contracted rent roll increased c 34% to £80m11 including like-for-like growth from completed rent reviews of 3.7%. Exhibit 3 provides a summary of financial performance.

In particular we note:

Since the end of FY22, SUPR has acquired an additional six supermarket assets for an aggregate £300m (before costs) at a blended NIY of 5.2%, adding c £16m to annualised contracted rent roll.

Just after the FY22 period end, SUPR entered into its first unsecured debt financing with a syndicate of banks, providing additional, more flexible debt funding. This was made possible by the increased scale and diversification of SUPR’s portfolio and was additionally supported by its recently awarded Investment Grade credit rating, itself a reflection of strong underlying sector fundamentals. The proceeds of the £412m were partly used in part to refinance existing secured commitments and provided £157m of net additional debt capital. The new unsecured facility was initially priced at a margin of 1.5% over SONIA, but SUPR has subsequently fixed the interest cost at c 2.8%, through new swaps, on £381m of the £412m total, for an average four years.

The agreement with Sainsbury’s also came after the FY22 period end, agreeing the sales price (at just over £1bn) on the 21 (of 26) stores to be sold to Sainsbury’s, agreeing new 15-year leases on four more and increasing SUPR’s estimate of the investment value of its share of the JV to c £190m.

Based on the company’s FY23 target aggregate DPS of 6.0p, the prospective yield is 5.8%, while the shares are now trading at a c 8% discount to end-FY22 EPRA NTA per share compares with an average 5% premium since listing. The current ratios are similar to those at the peak of pandemic uncertainty in 2020 which proved to be an attractive entry point, reflected in subsequent total accounting returns.

In Exhibit 5 we show a comparison of SUPR with a group of other property companies that focus on income returns derived from long leases. On a one- and three-year basis, SUPR’s share price has outperformed the average of this peer group and the broad UK property sector. Compared with the group average, it has a lower yield and higher P/NAV ratio. 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 and should prove resilient in the inflationary conditions that have followed. The non-discretionary nature of grocery sales has historically supported the sector in an inflationary environment and operators continue to mitigate input cost pressures through price increases.