Supermarket Income REIT — Strong accretive growth continuing

Supermarket Income REIT (SUPR), which is listed on the special funds segment of the London Stock Exchange, 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. Since IPO in July 2017, SUPR has paid increasing inflation-driven dividends and has generated consistently positive returns. For the year to 30 June 2020, the EPRA NAV total return (change in EPRA NAV adjusted for dividends paid) was 10.7%, taking the total since IPO to 20.4%.

Supermarket property has a long record of positive total returns underpinned by stable income returns in part due to the long length of lease commitments, and a strong occupier covenant as well as the non-cyclical nature of grocery retailing. Most (over 90%) of SUPR’s directly owned supermarket stores benefit from upward-only, inflation-linked rental uplifts, and the strength of tenant covenant is reflected in 100% of rental income due being collected in advance, with no defaults, deferrals or rent reductions. SUPR predominantly targets omnichannel stores that operate both as physical supermarkets and as online fulfilment centres, in strong locations, with asset management potential. The company firmly believes that omnichannel stores represent the future model of grocery in the UK, being able to benefit from both the expected growth of grocery sales and the increasing popularity of online, and as a result perform a critical role in the business strategies of the tenant operators. During the pandemic all the main grocery retailers have seen strong growth in sales, especially through online channels and driven by omnichannel stores (rather than dedicated online fulfilment centres), which have seen their share of online grocery orders increase significantly.

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 £5.0bn of supermarket transactions (including more than £1bn for SUPR) over the past decade. In March 2019, Justin King joined Atrato as a senior adviser. He is widely recognised as one of the UK's most successful grocery sector leaders, with a wealth of experience in the grocery sector and a deep understanding of grocery property strategy. He served as chief executive of J Sainsbury for 10 years until 2014, and before that was part of the leadership team at Marks & Spencer and previously held senior roles at Asda. Biographies for key members of the Atrato team can be found at the back of this report. Investment advisor fees are calculated according to a tiered structure, allowing shareholders to benefit more fully from portfolio growth and compare favourably in a sector context. 25% of the investment advisory fee is paid in shares and there is no performance fee.

SUPR has grown consistently and strongly since IPO, but the past 18 months have been truly transformational. Since the beginning of FY20, the directly owned investment portfolio, excluding the JV, has increased from £368m to c £975m (Edison estimate), while c £110m has been indirectly invested through the JV in a large portfolio of high-quality supermarkets leased to and operated by Sainsbury’s (the Sainsbury’s Reversion Portfolio). Portfolio growth is bringing increased diversification by tenant, store and geography, and is generating increasing economies of scale, supported by decreasing marginal investment advisory fees.

The FY20 increase in the value of the direct investment portfolio, from £368.2m to £539.4m, included the acquisition of three omnichannel supermarkets for an aggregate £148.8m (before costs), as well as like-for-like valuation growth of 4.3%, primarily driven by like-for-like rental growth of 2.5%. SUPR has since completed the acquisition of a further 17 supermarkets for a total consideration of c £435m before costs, continuing to diversify by asset, geography and tenant (adding Waitrose and Aldi for the first time). The proceeds of the highly successful £200m (gross) equity placing in October 2020 were quickly deployed by January 2021 in the direct acquisition of seven stores for a combined investment of c £245m (before costs).

SUPR initially invested £51m (before costs) in the Sainsbury’s Reversion Portfolio in May 2020 through a 50% stake in a newly established joint venture with British Airways Pension Fund. The 25.5% beneficial interest in the portfolio has now been increased to 51%, representing an additional investment by SUPR of £57.5m (before costs). The indirect investment in this portfolio of 26 well-performing, predominantly omnichannel stores should provide an attractive return on investment, at a rate in excess of the group target, and offers potential access to a valuable pipeline of assets which we believe shares similar characteristics to its current portfolio.

The directly owned investment portfolio now comprises 27 stores (plus some ancillary assets), for which we estimate a valuation (based on the end-FY20 valuations and the purchase values of assets acquired subsequently) of c £975m and annualised passing rent of c £52.3m. The Sainsbury’s Reversion Portfolio provides exposure to a further 26 stores. We estimate that the adjusted net loan to value ratio (LTV) is now close to 40% compared with SUPR’s medium-term target of 35-40%.

During FY21 year to date, SUPR has invested c £435m in its directly owned portfolio, acquiring a further 17 stores, and has committed an additional £57.5m to its joint venture with British Airways Pension Fund, maintaining a 50% interest in the vehicle, which has increased its beneficial interest in the Sainsbury’s Reversion Portfolio, a securitised portfolio of high-quality, predominantly omnichannel and well-performing Sainsbury’s supermarkets from 25.5% to 51.0%.

During the six months to 31 December 2020 (H121), 13 stores were acquired for a total consideration of £315m (before costs), at a blended net initial yield (NIY) of c 5.0%. This is a similar yield to the end-FY20 portfolio yield, although we believe it would have been slightly increased by the inclusion of some additional ancillary assets in two of the acquisitions at higher yields than the store assets. Nine stores were acquired for c £189m (before costs) by the end of September 2020, ahead of the highly successful £200m (gross) equity placing in October 2020, and an additional four stores have been added for a combined investment of £126m.

The nine store acquisitions made in H121 prior to the equity raise comprise:

Having completed the equity raise, SUPR completed the following 4 store assets before end-H121:

As at 31 December 2020 (H121), as reported in the SUPR’s Q221 Factsheet, the pro forma portfolio value (taking the end-FY20 valuation for existing assets and including the acquired assets at their purchase prices) was £854m and, including the JV equity interest at its c £56m end-FY20 value, the total portfolio valuation was £910m. The store portfolio valuation yield was 5.0% and the weighted average unexpired lease term (WAULT) was 16 years.

So far in H221, SUPR has acquired a further four stores, comprising:

Exhibit 4 summarises the recent strong growth in the fully owned portfolio. We estimate that the current pro forma portfolio value is now just under £975m (taking the end-FY20 valuation for existing assets and including all the assets acquired thus far in FY21 at their purchase prices) and, including the increased JV equity interest (at its c £56m end-FY20 value plus the further £57.5m investment), the total pro forma valuation is now approaching £1.1bn. We estimate a similar WAULT and NIY to end-H121.

The annualised passing rent on the direct portfolio is now c £52.3m, up from the £46.0m reported at end-H121, and includes c £2.7m in respect of the ancillary assets acquired alongside store acquisitions in Newcastle upon Tyne, Beaumont Leys, Winchester, Wisbech and Bangor. The ancillary assets represent a small share of the portfolio (c 3% by value) and are generally a by-product of SUPR’s desire to maintain fully strategic control over sites, while also providing asset management options. The store rent roll is predominantly (more than 90%) subject to upward-only, inflation-linked rent reviews, with the balance represented by fixed uplifts on the Waitrose at Market Harborough and Sainsburt’s at Bangor while the Tesco store at Beaumont Leys is subject to five-yearly open market rent reviews.

The joint venture with British Airways Pension Fund, in which SUPR has a 50% stake, first acquired a 25.5% beneficial interest in the Sainsbury’s Reversion Portfolio, one of the UK’s largest portfolios of supermarket properties, from British Land in May 2020. The JV has now increased its beneficial interest in the portfolio to 51% by acquiring a further 25.5% from Aviva. SUPR expects to earn an attractive return on its investment, ahead of the group average, and may benefit from the opportunity to acquire attractive assets from the portfolio, valued at £900.7m as at 30 June 2020, as the leases and securitised funding reach maturity in 2023.

The British Land interest in the portfolio was acquired by the JV for c £102m before costs (£105.2m including acquisition costs), a discount to the £111.2m book value of the interest at the date of acquisition. SUPR’s contribution to the JV was £52.6m, generating negative goodwill (a gain in the IFRS income statement) of c £3.0m in FY20. The Aviva interest has been acquired for £115.0m before costs, of which SUPR’s contribution to the JV is £57.5m. Based on the likely development of the portfolio book value since June 2020, we expect the Aviva interest has also been acquired at a discount to book value, at least sufficient to cover the costs of the transaction which we expect to be lower than those related to the first investment, including initial due diligence work. Based on the initial investment and on a full-year basis, SUPR’s share of the recurring earnings of the JV (excluding the negative goodwill impact) would have been c £5.5m (the reported contribution representing just one month of ownership was c £0.5m), a c 10% return on the invested value (before costs). We expect a similar annualised rate of return going forward on the increased beneficial interest (ie a SUPR share of c £11.0m pa).

Of the 26 stores in the reversion portfolio, 23 are omnichannel, offering physical shopping, click and collect and online home delivery, and most also incorporate an Argos. The average store net sales area is c 61,000 sq ft with an average gross internal area of approximately 79,000 sq ft. Although geographically diverse, around 60% of the portfolio is in London and the South East. The quality and trading performance of the portfolio is indicated by the fact that it represents c 4% of the total Sainsbury’s estate (by floorspace) but generates c 7% of annual sales.

The reversion portfolio was created through two sale and leaseback transactions in 2000 by Sainsbury’s, which has a 49% beneficial interest in the portfolio, occupies the stores and pays all the rents under the current occupational leases. Annualised rental income is currently c £53m and is subject to fixed annual uplifts of 1% per year. Reflecting the short remaining lease length, the portfolio net initial yield is c 5.5%, well above the SUPR portfolio yield of 5.0%, despite the quality of the assets. The portfolio is fully geared through a securitisation, with portfolio income used to service and pay down debt. Both the leases and the securitisation bonds mature in March and July 2023, and at lease expiry Sainsbury’s has the option to extend the leases for a further term of 20 years at the higher of passing rent or open market rent, subject to upward-only, five-year market rent reviews or to vacate the properties. Ahead of this, we would expect the leases to be renewed or the assets sold, allowing SUPR to benefit from a potential lease renewal or gain access to a valuable pipeline of assets which we believe share similar characteristics to its current portfolio. Although the JV contribution to expiry is ‘earned’ in the form of an increasing carrying value and is not immediately received in cash, it represents an attractive return. Given the increasing scale of the portfolio, we do not expect an impact on the inflation-linked progressive dividend policy.

Key to the visibility of income growth is the selection of properties with inflation-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:

All of the main UK grocery retailers have seen strong growth in sales during the pandemic, initially due to consumer stockpiling and subsequently as a result of more eating in and less eating out. Some of this will be temporary and will unwind as and when the reopening of bars and restaurants progresses, but it seems likely that a full return to the ‘old normal’ may never happen or may be some way off. IGD Retail Analysis forecasts for UK grocery sales have been increased for each of the next three years (Exhibit 6). The majority of grocery orders are still fulfilled within stores but online is the fastest growing channel and this growth has been dramatically boosted during the pandemic, supported by a massive increase in home grocery delivery capacity. Kantar data show that online grocery sales reached 12.6% in December 2020, a significant increase on 7.4% in the previous year. Atrato estimates that this significant growth has been focused on omnichannel stores (rather than dedicated online-only sales facilities), with c 80% of all online orders recently being fulfilled instore (omnichannel) compared with 74% pre-COVID. This was made possible by the supermarket operators flexing their estates to meet demand trends; for example, Tesco was able to more than double its online delivery capacity during the pandemic, to over 1.5 million slots per week. Although this online acceleration does not directly affect SUPR or the company’s contracted rental income, it underlines the key role of omnichannel stores in the distribution strategies of the operators and the long-term attractiveness of such stores to operators and investors. Atrato firmly believes that omnichannel stores are the future of UK online grocery retailing and that because of the capex required, dedicated online-only facilities are only really viable in areas of high population density, such as London, which are under-serviced by supermarket space relative to the rest of the country. Outside London, existing, relatively larger, full-range stores, in close proximity to population centres, make the omnichannel store model well suited for fulfilling the ‘last mile’ of online grocery distribution.

The sector has been fiercely competitive for many years and remains so. Low-price operators such as Aldi and Lidl have experienced strong sales growth, driven by new store openings and price competition, primarily taking market share from the smaller independent operators. The ‘big four’ (Tesco, Asda, Sainsbury’s and Morrisons) still have a combined share of c 66%, together operate more than 9,000 stores and represent strong covenant backing for long-term leases. The investment adviser believes that their ability to protect market share is in part due to the underlying nature of their store portfolios. As incumbents, they tend to have the largest sites in some of the best locations. It is too early to determine the longer-term financial impact of the pandemic on the operators, although the recent boost to sales from the pandemic and the increase in future industry grocery sales forecasts is a clear positive, offset in the near term by increased staff and safety costs and investment spend on increasing online delivery capacity. Ahead of the pandemic, the big four, led by Tesco, had been progressively improving cash flow generation through cost reduction programmes and enhancing balance sheet strength through sustained debt reductions.

Until around 2013, supermarket property had historically been priced at yields below the UK all-property sector. However, since 2013, in contrast to most other long income property yields, the supermarket sector has experienced a negative yield shift. This period of yield widening for supermarket property corresponded to the period of intense competition among the supermarket operators referred to above, and against a background of continuing growth in online retail and its transformational impact on traditional retail distribution. Investor interest in the supermarket property sector has picked up sharply over the past year or so, but the investment adviser believes the investment prospects for supermarkets remain favourable and that further increases in valuation are possible, citing:

Investment volumes in the UK supermarket sector remained exceptionally strong in 2020. Colliers estimates c £1.83bn, above the level in 2019 (£1.78bn), which was up 80% compared with 2018. We believe this reflects the typically long-term nature of leases, often inflation-linked, and the non-cyclical, low-volatility nature of the sector. Long-term investor buying interest was substantially met by institutional selling, particularly in respect of open-ended funds in search of liquidity. The investment manager notes that SUPR has been a key supplier of that liquidity over the past year and has been able to buy assets at attractive yields.

During FY20 the investment adviser, Atrato, formed a strategic sustainability partnership with EVOEnergy, the UK’s leading commercial renewable energy company, to evaluate, execute and manage a range of projects across the portfolio aimed at reducing carbon emissions. This will provide support for SUPR’s environment, social and corporate governance (ESG) policy and will be in step with similar policies adopted by the operator tenants, including their efforts to reach carbon neutrality by 2050. The first deliverable from the partnership is the installation of a 370kW rooftop solar array at the Tesco store in Thetford, which will provide c 310k kW per hour of carbon-free electricity. The required investment will improve the environmental sustainability of the site, while also generating an additional incremental income stream and enhancing the long-term capital value. There are plans for similar schemes across the portfolio.

FY20 earnings grew strongly, primarily driven by acquisitions but also including organic inflation-driven growth in like-for-like rental income (2.5%) with a positive impact on like-for-like property valuations (+4.3%) and NAV. However, the FY20 result did not capture the full earnings potential of the end-FY20 portfolio, and of course included no impact from subsequently completed acquisitions or the increased beneficial interest in the Sainsbury’s Reversion Portfolio. We briefly review the FY20 results and provide details of our forecasts.

In particular we note:

The fair value gain of £13.1m reported in the income statement included a gross revaluation gain of £22.4m (4.3% on a like-for-like basis), partly offset by acquisition costs written off and a small adjustment for IFRS rent smoothing. Revaluation gains were substantially driven by RPI-linked rental growth; the flat average portfolio net initial yield of 5.0% includes acquisition mix effects, valuation reductions on assets with shorter duration leases and gains on longer lease assets.

The directly owned acquisitions highlighted above have increased the annualised passing rent from £28.8m at end-FY20 to £52.3m, an increase of more than 80%, while we expect the increased interest in the Sainsbury’s Reversion Portfolio to add c £5.5m to EPRA earnings on an annualised basis. We estimate that SUPR has invested c £320m (including costs) since closing the October equity raise, substantially committing available equity and debt funding headroom to be consistent with its medium-term loan to value ratio (LTV) target of 30–40%. On a ‘pro forma basis’, adjusting the end-FY20 equity for the capital raise and subsequent investment (including our estimate of acquisition costs), we estimate an adjusted LTV of just under 40%, although this may well have been reduced by valuation gains over the period and we will have a clearer picture with the interim results on 2 March 2021. In any case, there remains significant flexibility within the expanded debt portfolio to fund further investment should SUPR choose to, but we do not assume this. Our other key assumptions include:

Across the sector, in recent years, supermarket rents linked to inflation have risen faster than open market rents, such that they are in many circumstances above market rent levels. This will typically act as a drag on valuations as lease expiry approaches (particularly where the unexpired lease length falls below 10 years), reflecting the potential future income decline. SUPR’s long 16-year weighted average WAULT mitigates the risk of negative portfolio valuation impacts for many years to come, while the potential to re-gear leases on well-performing stores, well ahead of lease expiry, should also provide an offset. Asset management also offers the potential to increase rental income and potentially extend leases. Valuations may be further protected by carefully selecting stores with good potential for alternative use over the longer term.

Exhibit 14 shows a summary of our forecasts. We expect FY22 rental income to more than double compared with FY20 as acquisitions make a full-year contribution, with a geared impact on EPRA earnings due to economies of scale. As a result, we expect DPS to continue to increase with inflation and be well covered by EPRA EPS (c 1.1x in FY21 and increasing to c 1.2x in both FY22 and FY23). On an adjusted EPRA EPS basis (which excludes the non-cash JV contribution), we expect DPS to be substantially covered (c 0.9x in FY21 and increasing through FY22 and FY23). We expect a dip in EPRA NAV per share in FY21 as a result of significant acquisition costs written off, continuing to increase thereafter.

SUPR has continued to expand its banking relationships and broaden its portfolio of debt facilities over the past year and we expect this to continue.

Total debt at end-FY20 was £128.5m and after adjustment for cash balances, the net loan to value ratio (LTV) was 19.7% (net debt/investment properties) or 17.9% if adjusted for the JV equity (net debt/investment properties plus JV equity). We focus on the adjusted LTV in this report. For completeness, SUPR also provided the LTV on a ‘look-through’ basis as if its share of the JV portfolio and debt were consolidated into its own balance sheet. As the JV is a securitised vehicle (although the debt amortises over time), this shows a higher LTV (22.3% at end-FY20).

New facilities arranged in FY20 included a fully drawn £76.6m term facility (five years plus two one-year extension options) with DekaBank at a fixed coupon of 2.0% arranged in August 2019, and further facilities have been agreed in FY21 including:

Total debt facilities available to the group of £228.7m at the end of FY20 have since increased to £443.5m, as shown in Exhibit 15. We forecast total borrowing of up to c £450m (adjusted LTV c 39– 40%), which implicitly assumes some small exercise of the accordion options amounting to up to £200m.

The recent financing activity has significantly increased the average maturity of the debt facilities; we estimate a current average c 5.5 years. All of the debt is floating rate, but a hedging strategy is in place designed to mitigate the impact of any significant rise in interest rates. We estimate that including the cost of hedging, the average running cost of the group’s total debt facilities is c 2.0%.

There is significant headroom on debt covenants, which include a maximum 60% LTV threshold and minimum 200% interest cover ratio for each asset in the portfolio. As at end-FY20, it would require a 38% reduction in property values to breach the LTV covenant. Interest cover for the group is currently around 600%.

The company has recently indicated that it continues to identify further suitable acquisition opportunities that meet its strict selection criteria and, with current capital resources now effectively and successfully deployed, in time we would expect it to seek additional capital. The October 2020 issue of 192.3m new shares formed part of the placing programme, approved by shareholders, which allows for the issue of up to 450m shares in total during the 12 months commencing 17 September 2020. The placing programme provides greater flexibility to tailor equity issuance to the immediate pipeline in order to minimise cash drag. Share issuance at a discount to NAV is not allowed under the programme and the intention is that shares should be issued at a premium to NAV sufficient to at least cover issuance costs.

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, which the company expects to be in the 30–40% range over the medium term and once the portfolio growth phase moderates.

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 EPRA NAV plus dividends paid) has steadily increased, reaching 10.7% in FY20 and taking the cumulative total to 20.4% since IPO (dividends paid added back but not reinvested). The compound annual accounting return of 6.5% increases to 10.0% if the significant property acquisition costs incurred in building the portfolio are added back. Dividends have been increased in line with inflation each year and dividends paid in the period represent 78% of the accounting total return since IPO, or 49% if returns are adjusted for acquisition costs.

Our forecasts indicate a dip in NAV total return in FY21, primarily as a result of acquisition costs incurred in the growth of the portfolio, and despite the swift deployment and minimal ‘cash drag’ from investment of the significant equity proceeds raised. With current equity capital resources deployed and geared during FY21, our FY22 forecasts assume no acquisition cost impact and, supported by a full-year revenue impact from the FY21 acquisitions with economies of scale/reduced cost ratio, we forecast a FY22 total return at the top of the target range.

Based on the company’s FY21 target aggregate DPS of 5.86p (SUPR shares yield a prospective 5.4%.) The share price premium to end-FY20 EPRA NAV per share is 8%, although we expect NAV per share to reduce slightly in FY21 as a result of the acquisition costs incurred. Based on our FY21e EPRA NAV per share, the premium is 11%.

In Exhibit 17 we show a comparison of SUPR with a group of other property companies that focus on income returns derived from long leases. Within the group, valuations and performance over the past year partly reflect investor perceptions of the strength of the tenant covenant. For example, the primary healthcare investors (Assura, PHP), where rents are paid directly to the companies by government or indirectly via GP reimbursement, have below average yields and above average P/NAV ratios. Compared with the group average, SUPR has a higher yield and similar P/NAV ratio to the average. Its RPI-linked rent growth provides investors with considerable visibility of income with protection against inflation, and the strength of its tenant covenant has been successfully tested during the pandemic.

The visibility to SUPR’s contractual income is provided by long leases and inflation-linked rent increases. Additionally, the company plans further accretive acquisition of assets. We see the key sensitivities as relating to the following: