Supermarket Income REIT — Maintaining returns, with accretive opportunities

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, it has progressively increased dividends, fully covered by earnings, and this has been the driver (more than 60%) of the 7.7% pa NAV total return, within its medium-term target range of 7–10%, despite the significant capital weakness in H123. We forecast DPS to be maintained and fully covered, representing a 6.5% yield on the H123 NAV per share of 92p, and this should underpin a continuation of near-term returns at a level broadly in line with the target range. Over the longer term, SUPR estimates that the inflation impact on income, despite higher funding costs, has the potential to lift the internal rate of return (IRR) on investment by c 200bp, on both a leveraged and unleveraged basis (pages 6–7).

We have increased our forecasts for EPRA earnings, with reduced expenses more than offsetting higher interest costs. Expenses benefit from lower investment manager fees (linked directly to NAV) in particular. Our forecast for higher interest costs better reflects the current fixed cost of borrowing as well as the maturity and refinancing of that borrowing, commencing in August 2024 (H125) (see Exhibit 4). We also allow for the recent acquisition, for £38.3m before costs, of a Tesco store in Worcester, as well as assuming that SUPR will exercise its option to acquire four of the remaining five Sainsbury’s Reversion Portfolio (SRP) assets, for £28.3m. However, we assume that most of the SRP proceeds of £431m are used to repay borrowings, reducing LTV to a little under 30%.

The sale of SUPR’s 51% beneficial interest in the SRP, which included a 25.5% beneficial interest acquired in January 2023, to Sainsbury’s, completed in March. Details of the January transaction are contained in our January update note, but in brief, this was aimed at strengthening SUPR’s positioning ahead of the winding up of the SRP structure while deepening its relationship with Sainsbury’s and enhancing SUPR’s return.

As we have previously commented, SUPR’s investment generated highly attractive returns for the company, with the disposal reflecting a money multiple of 1.9x and an IRR of c 30%. On completion of the sale, SUPR received £279.3m, partly used to repay in full a £202.8m debt facility provided by JPMorgan Chase in January 2023 that provided short-term funding for SUPR’s acquisition of a further 25.5% interest (part of the final 51%). In addition to this first tranche, SUPR will receive £116.9m in July and a third tranche of £34.7m, conditional on the sale of the remaining five stores in the SRP, making a total of £430.9m. Based on the 31 December 2022 (end-H123) portfolio valuation, SUPR indicated an LTV of a little under 30% following receipt of the first two tranches.

The SRP portfolio had comprised 26 freehold stores, of which 21 were acquired directly by Sainsbury’s. The SRP, in which Sainsbury’s now has a 100% interest, retains five stores, four of which are leased to it on new 15-year leases (with five-yearly open market rent reviews and a tenant break option at year 10) and a fifth that is to be sold with vacant possession. SUPR has an option to acquire the four regeared stores for a net consideration of £28.3m (net of SUPR's existing interest and excluding acquisition costs), which we expect it will exercise All the stores are omnichannel, supporting both online delivery and click and collect within their respective catchments. The rent has been set at a very affordable level and SUPR expects all stores to receive renewed investment from Sainsbury’s in the short to near term, underlining Sainsbury’s long-term commitment to them.

Net of the Worcester acquisition and the assumed acquisition of the four SRP stores, we estimate c £150m of remaining funds available for deployment, which, in our forecasts, represents a reduction in debt, additional to the JPMorgan Chase repayment.

SUPR’s interest rate hedging is matched to the well-spread maturities of its various debt facilities, diversified across a range of lenders, fixing the cost of drawn borrowing at 2.9%, with a blended average maturity of around four years.

Based on current market expectations for interest rates, reflected in the SONIA forward curve, as the hedges roll over the blended average cost of debt will increase.1 In Exhibit 5 we have extended our forecasts for the period to end FY24 to end FY27, by which time the vast majority of this adjustment will be complete.2 We have assumed that maturing debt is refinanced at a fixed 5% throughout and that indexed rental growth continues at 3.5%. Despite the significant increase in borrowing costs that we have assumed, this is compensated by rental growth, with full dividend cover maintained.

There are indications that pressures on the banking system may limit the availability of real estate lending but, were this to be the case, we would not expect a material impact on high-quality supermarket assets with secure and visible income. Depending on the development of financial markets, we would expect SUPR to seek an extension of its debt maturity over time, where this would lock in a positive spread between asset yield and financing costs, which would increase over time with indexed rent growth. Utilisation of the unsecured corporate bond market, leveraging the company’s scale, strong fundamentals and investment-grade credit rating, would potentially add to funding flexibility.

The debt repayment assumed in our forecasts is just one of the options open to SUPR for the deployment of the SRP proceeds.

In Exhibit 6, we compare the earnings impact of reinvestment or share repurchases on a full year (FY24) basis. On this near-term basis, both have a similar positive impact on our forecast earnings, although over a longer period the reinvestment scenario would additionally benefit from rental growth on the assets acquired.

In the ‘investment scenario’, we have assumed that remaining (c £150m) SRP proceeds (see Exhibit 3), which are net of the £66.6m (before costs) of acquisitions already included in our forecasts, are invested at a 5.85% net initial yield. This increases LTV to 35%, in line with SUPR’s medium-term target. The additional finance expense is based initially on 2.9% pa, in line with the savings on debt repayment reflected in our forecasts, and generates immediate accretion of 0.4p per share. We expect this accretion to be maintained as rental growth offsets the eventual increase in borrowing costs.

Alternatively, maintaining LTV at 35%, we estimate that almost £100m would be available for share repurchases, or c 9% of the shares outstanding. At the current share price, we estimate EPS accretion of 0.4p, but, unlike portfolio investment, there would be no benefit from future rental growth.

SUPR remains very confident about the sector, and its omnichannel-focused portfolio (93% by value) in particular, and sees strong opportunities to deploy capital at an increased yield. The current portfolio offers the prospect of secure long-term (14-year WAULT3), mostly inflation-indexed rental income (80%) from high-quality tenants (Tesco and Sainsbury’s represent 78% of end-H123 portfolio rents), operating in a structurally supported sector. Meanwhile, inflation has increased prospective potential returns on the current portfolio and acquisitions to a level that is well above risk-free rates.

As inflation has spiked upwards and interest rates have increased, supermarket property has repriced even faster than the broad UK property market, with market valuation yields rising by c 90bp. This has been reflected in the valuation of SUPR’s portfolio, with the net initial yield increasing to 5.5% from 4.6% in June 2022, and is also mirrored by the market transaction data series compiled by the company’s investment adviser, Atrato Capital.

The above market average yield widening comes despite a number of positive influences, including:

Atrato estimates that the correction to acquisition yields has significantly increased the projected IRRs on acquisitions. The following illustrative example5 shows an increase of more than 2% pa on both an unlevered and levered basis.

Underlining its ability to deploy capital at attractive yields, in late April SUPR announced the acquisition of a Tesco omnichannel supermarket in Worcester for £38.3m before costs, reflecting a net initial yield of 6.0%. The yield is in line with similar profile stores within SUPR’s portfolio, providing support to the 31 December 2022 valuation. The store was acquired from British Steel Pension Fund, with an unexpired lease term of 12 years and annual upward-only, RPI-linked rent reviews (subject to a 4.0% cap and 0.0% floor). Although the lease length is relatively short, within the context of SUPR’s overall portfolio, Tesco has a long (more than 30 years) trading history on the site, which also serves as an online hub, operating nine home delivery vans and a click & collect facility.

Additional acquisition opportunities with Sainsbury’s are also possible now that SUPR is no longer in the position of being a potential seller of stores to Sainsbury’s. We note that Sainsbury’s continues to undertake sale and leaseback transactions and that in September 2022 it came close to completing a £500m transaction with LXi REIT, aborted as market volatility increased.

Quarterly DPS is running at an annualised rate of 6.0p, representing a yield of c 7.0%, well above the 5.4% average since listing in June 2017. Meanwhile, the shares trade at a c 9% discount to H123 NAV compared with an average 4% premium since listing.

In Exhibit 11, 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. Excluding the social housing investors (Triple Point Social Housing and Civitas), SUPR’s yield and P/NAV show no material divergence from the peer group average.

H123 results continued to show the impact of strong portfolio growth. During the period, SUPR acquired a further eight stores for an aggregate £299m and in total, over the 12 months since end H122, it has purchased 12 stores for an aggregate £437m.

On an IFRS basis, H123 rent roll increased £17.9m or 36% to £98.1m pa versus H122. This included £16.6m from acquisitions and 3.7% like-for-like growth or £1.2m.

Although not immune to the property yield widening seen across the UK commercial property sector in the second half of 2022, supermarket property has been less volatile, and the 13% like-for-like decline in SUPR’s portfolio in H123 compares favourably with the c 19% decline in the broad market indicated by MSCI data.

The key features of the H123 results include:

During H123, SUPR undertook significant financing activity, extending and broadening its banking relationships.

Early in the period, in July 2022, it agreed a new £412m unsecured credit facility with a bank syndicate comprising Barclays, Royal Bank of Canada, Wells Fargo and Royal Bank of Scotland International, priced at 1.5% above SONIA with a weighted average term of six years (inclusive of uncommitted extension options). The proceeds were part-used to repay £255m of existing debt. In September, the maturity of the existing £150m revolving credit facility (RCF) with HSBC was extended by two years (inclusive of a one-year accordion option, subject to bank approval), with all other terms remaining the same.

With interest rates remaining volatile, SUPR decided to fix all drawn debt at 2.9% through the expected peak of the market interest rate curve (see footnote 1). To fix the cost of the drawn floating rate debt exposure, the company entered into three interest rate swaps, covering £381m of borrowings, and purchased an interest rate cap on £96.5m of the HSBC RCF until August 2024.

The cost of acquiring these interest rate derivatives was £41.4m, to be amortised though the income statement over their average four-year term.

Post period-end, in January, SUPR borrowed £202.8m from JPMorgan Chase on a short-term basis to fund the purchase of its increased beneficial interest in the SRP and it was subsequently repaid in full using the first tranche of the sale proceeds. The existing loan facilities with Bayerische Landesbank (BLB) were also refinanced in March 2023, with a new three-year £86.9m term loan fixed at an all-in rate of 4.29%.

Following these refinancings, SUPR has £862m of total borrowing facilities, £172m of which was undrawn at end-H123. The £38.3m acquisition of Tesco, Worcester was financed from the remaining proceeds of the first tranche of the SRP sale proceeds.