Supermarket Income REIT — Supermarket sweep

SUPR continues to grow strongly through accretive acquisitions funded by increased equity and debt capital resources. Meanwhile, the market in which it operates is benefiting from strong supermarket operator performance, particularly for the omnichannel stores that SUPR targets, further enhancing income security and supporting strong investor demand for supermarket properties. This strong demand is driving up asset prices and SUPR’s NAV but is compressing acquisition yields. We nevertheless expect the strong asset sourcing capabilities of the investment adviser (transactions are typically off-market and therefore somewhat less competitive) and SUPR’s low average cost of debt to support continuing accretive acquisition led growth, especially when combined with economies of scale. The impending maturity (in the first half of calendar 2023) and subsequent unwinding of the Sainsbury’s Reversion Portfolio securitisation vehicles in which SUPR has a 25.5% interest, and reported as a joint venture (JV), will also generate NAV growth and cash for redeployment. We assume deployment will be into further asset growth but should acquisition yields compress to a level where this no longer creates value we expect SUPR to consider alternative options, including a return of capital to shareholders.

In this note we focus on these developments. A detailed review of SUPR’s strategy, including its strict asset selection criteria, can be found in our last note. As detailed below, we forecast further strong, accretive asset growth as the proceeds of the recent £200m (gross) equity raise and the cash return from the JV unwind, with associated gearing, are deployed into a strong near-term and longer-term acquisition pipeline. The prospect of higher inflation for an extended period is beneficial for organic income growth. Our NAV forecasts assume unchanged yields (plus uplifts from the JV) although the prospects for further yield contraction are favourable (and expected by the investment adviser).

SUPR’s most recent equity raise closed on 20 October 2021 with 173.9m new shares issued at 115p per share to raise £200m (gross). The issue was very well received by investors with a scaling back of subscriptions despite an increase in the target issue size from up to £100m to up to £200m, reflecting both the strength of demand for the shares and a strengthening of the acquisition pipeline during the issue roadshow. The investment adviser had identified four assets with an estimated aggregate purchase value of c £180m (the ‘target assets’), three of which were under exclusivity1, and a further seven assets that also meet the company’s strict acquisition criteria, with an expected aggregate value of c £480m (the ‘pipeline’). It has since completed the acquisition of three of the target assets comprising:

The Tesco site in Maidstone, Kent, was purpose built for Tesco in 1990 and extensively refurbished in 2007. This seven-acre site comprises a 39,000 sq ft net sales area supermarket, a 12-pump petrol filling station, 369 car parking spaces and a small parade of adjoining units. It was acquired with an unexpired lease term of 13 years, with five-yearly, upwards only, open market rent reviews.

Progress with deploying the recent equity raise proceeds builds on SUPR’s strong record of swift capital deployment, 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. It has generally been able to deploy equity proceeds within three months and achieve full deployment, including associated debt capital, within six months. Deployment of the £150m (gross) equity placing in March 2021 took slightly longer than normal but within six months c £185m (including costs) had been invested.

From the existing strong pipeline of acquisition opportunities, we assume an additional £150m (before costs) of deployment by the end of June 2022 (end-FY22), fully deploying the equity raise proceeds on a geared basis. Available debt capacity is discussed in detail in the following section. We have assumed a net initial yield on investment of 4.5%. This implies a full use of SUPR’s existing £644m of debt facilities and an end-FY22 net loan to value ratio (LTV) of c 40%.

In the following section we discuss the maturity and unwind of the JV in the first half of calendar 2023 (H223). Until then we assume no further capital deployment from the existing capital base, although since its initial public offering (IPO) it has shown a consistent ability to identify attractive assets and access the equity and debt capital required to fund their acquisition.

Upon receipt of the JV proceeds we assume a further £300m (before costs) of re-deployment, also at a 4.5% net initial yield, in early FY24. This is consistent with a net LTV of c 40% and, we estimate, will require additional debt funding of at least c £125m.

SUPR’s 50:50 joint venture with British Airways Pension Fund has a 51% beneficial interest in a portfolio of 26 high-quality supermarket stores (‘the Sainsbury’s Reversion Portfolio’), let to Sainsbury’s, and valued at £932.5m at 30 June 2021. The reversion portfolio was created through two sale and leaseback transactions (Highbury Finance and Dragon Finance) 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, which expire in March 2023 and June 2023. SUPR’s indirect beneficial interest in the portfolio was acquired in two tranches, at a discount to book value, representing an investment of £108.5m (before costs) and was valued at £130.3m at 30 June (end-FY21). The investment generates a strong recurring return for SUPR (before valuation movements) of c £12.6m pa, a c 11% return on its investment. It also provided SUPR with potential access to a valuable pipeline of assets or the opportunity to benefit from lease renewal or, as now seems to be the case, the sale of the assets at a premium to book value.

In September, SUPR announced that Sainsbury’s has exercised a purchase option to acquire 13 of the 26 freehold stores., which will be completed in March 2023 on expiry of the current occupational leases. The price that Sainsbury’s will pay to acquire the stores will be based on the market value of an assumed new 20-year lease to Sainsbury's with the initial rent set at the higher of passing or open market, subject to upward-only, five-yearly market rent reviews. We expect this to be well above the 30 June valuation and to generate an uplift in the value of SUPR’s investment and its NAV. In addition, Sainsbury's has a remaining purchase option to acquire a further 10 stores in the reversion portfolio, which it can be exercise between December 2021 and January 2022, for completion in June 2023. We expect Sainsbury’s will exercise its purchase option over most of these stores with a further uplift in the value of SUPR’s investment.

Sainsbury’s will continue to pay rent until completion, and SUPR’s beneficial interest will continue to generate recurring returns, although we expect an uplift in valuation and SUPR’s NAV as Sainsbury’s exercises its options (with the exercise over 13 stores benefiting SUPR’s H122 NAV).

Where Sainsbury’s does not elect to repurchase the stores, we expect they will be sold, although some may continue to be leased by Sainsbury’s.

The price that Sainsbury’s will pay for the stores that it acquires will reflect their quality of the stores and the assumption of a long lease length (20 years) with upwards only reviews. At 30 June 2021 the valuation of the stores, with modest remaining lease length, reflected a net initial yield of 5.3% whereas current market transaction activity suggests a level of c 4.5%.

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. Of the 26 stores, 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.

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). With strong investment demand for supermarket assets, most recently encouraged by the strong performance of the supermarket operators through the pandemic, yields have continued to compress to c 4.5% (and SUPR expects a further compression as discussed below, particularly for the omnichannel stores3 that it targets).

At this stage we do not know to what extent Sainsbury’s may exercise options over the further 10 assets (Dragon Finance) during December 2021 and January 2022. Sainsbury’s exercised its purchase option in respect of 13 of the 16 Highbury Finance assets, or c 80% of the total. This may be a reasonable guide to the Dragon Finance outcome, and we have assumed this in our forecasts (eight of the 10 Dragon Finance stores). Although we believe that all of the assets are of good quality, we presume that Sainsbury’s will in fact ‘cherry pick’ the assets to acquire (although it will undoubtedly have other considerations) and we therefore attach a higher net initial yield to the assets not acquired. Our central assumption is that the assets acquired by Sainsbury’s are at a valuation that reflects a 4.5% net initial yield and, perhaps conservatively, attach a higher 6.0% yield to the other assets. This implies an increase in the overall reversion portfolio property assets from the 30 June value of £932.5m to £1,045.5m, or 12%, reflecting a blended net initial yield of 4.7%.

In Exhibit 4 we illustrate the sensitivity of the reversion portfolio valuation and SUPR EPRA net tangible assets (NTA) to alternative assumptions for the net initial yield of the assets where we assume Sainsbury’s to exercise its purchase option as assumed in Exhibit 3. We show this in relation to end-FY21 EPRA NTA as our FY22 forecast already includes a valuation uplift based on a net initial yield of 4.5 % (for these assets only). Including recurring income up to mid-2023, which is not received in cash by SUPR but is recognised in the value of its investment, we forecast a closing value for the JV investment of £180.3m by June 2023 (end-FY23), received in cash as the JV is unwound, and reinvested early in FY24.

Although asset yields have compressed since SUPR’s IPO, SUPR has continued to identify attractive acquisition opportunities, supported by a low cost of capital. The FY22e DPS of 5.94p represents a 5.2% yield on the 115p issue price for the September equity raise, while the average running cost of its debt facilities is 1.8%. Although most of the debt is floating rate more than 60% is hedged. However, over time we would expect SUPR to seek longer-term and fixed-rate funding. The company has grown to a scale where, combined with stable, predominantly indexed-linked rental income and strong tenant covenants, access to the unsecured sterling bond market is a real possibility. In current market conditions we would expect the bond market to provide longer maturity debt at a similar overall cost. Moreover, an unsecured bond funding platform should provide increased funding flexibility than is the case with secured debt.

Since IPO, SUPR has targeted a medium-term LTV of 30–40% but we expect it to operate towards the top of this range reflecting the increased scale and diversification of the portfolio as well as the improving financial position of tenants. Based on an LTV of 40%, the equity raising dividend yield and current cost of debt imply a blended capital cost of c 3.8%. Including investment adviser fees at a marginal rate of 0.65% of NAV we estimate a ‘break-even’ acquisition yield of 4.3%, which continues to provide a margin for SUPR to grow without diluting dividend cover. We would not expect SUPR to strictly benchmark every transaction 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. We assume a net initial yield of 4.5% on future acquisitions.

Active debt financing during FY21 and continuing into FY22 includes new facilities with Barclays/Royal Bank of Canada and Wells Fargo and extensions to facilities with HSBC and DekaBank. The increase in debt capacity has been achieved at a slight reduction in SUPR’s already low cost of debt. At the end of June 2021 (end-FY21), SUPR had total secured debt facilities of £514m plus a further £100m accordion option to extend its £60m revolving credit facility (RCF) with Wells Fargo, of which £413m had been drawn. In September it announced an increase of £20m in its term loan facility with DekaBank, a £10m increase in its HSBC RCF, and the exercise of £61.3m of the £100m accordion option attaching to the Wells Fargo RCF (£39m remains undrawn and exercisable at any time).

Including undrawn accordion options, total facilities now amount to £644m, of which £515m had been drawn as at 23 September 2021 with £129m remaining undrawn. Our capital deployment forecasts assume the facilities are drawn in total by end-FY22.

The interest rates on Bayern LB and Dekabank facilities are fixed at attractively low levels and SUPR operates a hedging strategy designed to mitigate the impact of any significant rise in interest rates that would impact the floating rate debt4, including tighter monetary policy to combat inflationary pressures. Approximately 55% of end-FY21 drawn borrowings were fixed or hedged, in line with the 55%-60% that SUPR is managing to. Of the expanded total debt facilities c 40% are currently fixed or hedged. The average running cost of the group’s total debt facilities of c 1.8% includes the cost of this hedging.

As Exhibit 2 shows, market acquisition yields for the assets that SUPR targets have compressed from c 5–6% at IPO to c 4.5% currently, and this has been reflected in the valuation of SUPR’s portfolio5 and NAV. In FY21, like-for-like portfolio valuation growth was 8.5% with 4.1% growth in the valuation of assets acquired during the year.

SUPR’s investment adviser sees a strong potential for further yield tightening. As we discuss elsewhere, this would be positive for NAV growth but reduces the income benefit of continued growth. We do not expect SUPR to chase non-accretive growth and, if acquisition yields compress beyond a certain level, we would expect SUPR to curtail investment. We do not forecast yield changes but estimate that a 10 basis point compression of the net initial yield of SUPR’s wholly owned supermarket portfolio (as at end-FY21) would add c 2.7p or c 2.5% to NAV per share.

Yield compression has been 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. 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. There is no sign of a let up in investment activity and SUPR’s investment adviser notes that while asset yields have compressed the spread versus operator/tenant unsecured debt yields have actually widened. Even before the pandemic boost to sales, the big four operators, led by Tesco, had been progressively improving cash flow generation through cost reduction programmes and enhancing balance sheet strength through sustained debt reductions. The continuing improvement in financial strength and prospects has contributed to a greater tightening in unsecured bond yields6 than has been the case for supermarket property yields. As an indicator of tenant covenant strength, the investment adviser anticipates that property yields will follow.

Full-year results to 30 June 2021 (FY21) were published on 23 September. Between the FY21 year end and publication of the results, significant acquisition activity had already taken place and SUPR has subsequently raised £200m (gross) of equity. We provide an overview of the FY21 results at the back of this report but focus in this section on our forecasts. It is worth mentioning that the ‘core’ FY21 results were very much in line with our forecasts, but our EPRA earnings forecast incorrectly included £3.3m of negative goodwill (a positive income statement item). Adjusting for this, rental income, EPRA earnings and EPS, and DPS were all as we expected, while property valuation gains and EPRA NTA per share were well ahead of our expectations (Exhibit 6).

We have updated our FY22 and FY23 forecasts, primarily to reflect the equity raise and our expectations for its geared deployment. We have extended our forecasts to FY25 to capture the impact of the FY23 JV unwinding and reinvestment of the proceeds on a geared basis (we assume in early FY24) on a full-year basis (the first full-year contribution being in FY25).

As detailed above, we have included the three transactions announced since the equity raise, amounting to c £149m (before costs) and assume the following further acquisition investment, all at a 4.5% net initial yield:

Our other key assumptions include:

A summary of our forecasts is shown in Exhibit 6. While we forecast further strong growth in rental income and EPRA earnings, our EPRA EPS forecasts for FY22 and FY23 are reduced. This reflects:

We nonetheless continue to expect DPS growth in line with our inflation assumptions and for this to be well covered (c 1.1x) by EPRA earnings.

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 30–40% 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 12.1% in FY21, taking the cumulative total since IPO to 33.0% (dividends paid added back but not reinvested) or a compound 7.5% pa. Returns would be higher if adjusted for the c 7.1p per share of acquisition costs incurred in building the portfolio since IPO. Dividends have been increased in line with inflation each year and represent two-thirds of the total return since IPO.

Our forecasts indicate a continuation of returns in line with recent experience and the company’s target range, reaching the top of that range by FY25 as scale builds further and assuming no acquisition costs in the year nor any further compression of valuation yields. Yield compression, for which there are positive indicators, would have a positive impact on our forecast returns.

Based on the company’s FY22 target aggregate DPS of 5.94p the prospective yield is 4.9%. The share price premium to end-FY21 EPRA NTA per share is 1.13x.

In Exhibit 8 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 slightly higher yield and slightly 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, suggesting the potential for further supermarket property yield tightening and NAV growth above our forecasts.

Exhibit 9 summarises the reported FY21 financial performance although, as noted above, SUPR had already completed a significant number of acquisitions before the results were announced. To illustrate the impact the FY21 acquisitions would have had on a full-year basis along with the post-FY21 acquisition contribution, SUPR provided pro-forma 12-month results. We first review the reported FY21 results, which demonstrate strong ongoing growth and scale efficiencies and then the pro-forma position.

In brief we highlight:

Acquisitions completed since FY21 and rent reviews subsequently completed have increased annualised rents from £60m to £64.9m. These are included the pro-forma results shown in Exhibit 10 on a full-year basis. Interest expense also assumes a full-year impact of debt drawn during FY21 and subsequently to fund post-FY21 acquisitions. The cost of dividends reflects the end-FY21 number of shares and FY21 DPS on a full-year basis. EPRA EPS increases by 25% and EPRA dividend cover to 1.20x. This does not represent the actual FY22 result that may be expected as it does not include the effects of the September equity raise and future equity and debt deployment.