Supermarket Income REIT — Visible, long-term income growth

Supermarket Income REIT, 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, with a 7–10% pa total shareholder return target over the medium term.

The long indexed-linked leases that SUPR targets provide a high degree of visibility to contractual income streams, and strong income returns for supermarket property have underpinned a long record of positive total returns, making this a relatively low risk segment of the UK commercial property market.

UK consumer spending on grocery products has grown each year since 1999, and is forecast by IGD Retail Analysis to grow by a further 15% over the next five years. The supermarket sector has been through a period of intense competition but the incumbent ‘big four’ operators (Tesco, Sainsbury’s, Asda and Morrisons), which SUPR expects will continue to represent the majority of its tenant base, have retained a dominant market share (c 70%) and have recently experienced an improving trend in sales and margins, reflected in share price outperformance of the broader market. The investment adviser believes that their ability to protect market share is in part due to the underlying nature of their store portfolios, which also underpins their online strategies. As incumbents, they tend to have the largest sites in some of the best locations, around which they have built a network of omichannel stores, combining traditional supermarkets (still the dominant channel by far, and growing) with online (with a c 6% share but the fastest-growing channel). As it targets a sustainable and growing income stream, SUPR only invests in omnichannel stores, which the investment adviser estimates account for 74% of all online grocery fulfilment.

Including the acquisition completed in July, the investment portfolio now comprises six supermarket assets, each combining in-store and online fulfilment, with a value of c £317m. The annualised rent roll is c £16.3m and each of the leases is RPI-linked with a weighted average unexpired lease term of more than 19 years. SUPR continues to see opportunities in the market to further grow the portfolio while meeting its investment objectives.

The company has an independent board of non-executive directors and has appointed Atrato Capital as investment adviser.

The external investment adviser appointed by the board is Atrato Capital, established in 2016 by Ben Green and Steve Windsor (biographies on page 12). 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 £4.0bn of supermarket transactions over the past decade. This sector knowledge and the strength of Atrato’s industry contacts have been key factors behind the fast deployment of investment capital. The fees paid to the investment adviser are on a sliding scale, from 0.95% of net assets up to £500m and reducing to 0.45% of net assets above £1.5bn, and compare favourably with the peer group average, especially for higher NAV levels. The fee is payable 75% in cash and 25% in shares with a 12-month lock-up.

Supermarket lease agreements are often long-dated (typically 20–30 years at inception without break options), fully repairing and insuring, and subject to upwards-only rent review linked to inflation. Such lease terms, provide a high degree of visibility to contractual income streams, and strong income returns for supermarket property have underpinned a long record of positive total returns, making this a relatively low risk segment of the UK commercial property market. The investment advisor believes that secure, long income, supermarket property leases, with index linked rent can, currently, be acquired at attractive investment yields, and that real estate investors are undervaluing the inflation protection characteristics embedded in supermarket leases when compared to other comparable inflation-linked products. With UK index-linked gilts trading at negative real yields since 2013, the investment manager believes that the implied risk premium attached to large supermarket group tenants has the potential to narrow in line with improved operator performance.

UK consumer spending on grocery products has grown each year since 1999 and is forecast by IGD Retail Analysis to grow by a further 15% over the next five years, from £190bn in 2018 to £218bn in 2023. According to IGD, hypermarket and supermarket stores account for c 55% of sales, and although sales are expected to grow, it is convenience and discount formats – and above all for online sales – that are expected to show the fastest five-year growth. Although growing strongly, online sales are currently only c 6% of the total, with consumers showing a preference for selecting fresh produce in person. The majority of online grocery orders are fulfilled from within supermarkets (the investment adviser estimates 74%) rather than dedicated online fulfilment centres, with the major operators operating a network of omnichannel stores, combining traditional supermarkets (still the dominant channel by far, and growing) with online (the fastest-growing channel). Around 90% of Tesco fulfilment is from supermarket stores, and it is five years since the last of their six online-only fulfilment centres was built. The investment adviser believes 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 of London, existing, relatively larger, full-range stores, in close proximity to population centres makes 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 70%, and together operate more than 9,000 stores. 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.

Supermarket property has historically been priced at yields below UK all-property sector; however, this has not been the case since c 2015 (see Exhibit 1). Supermarket property yields have increased in recent years, even as the broader UK commercial property market and the distribution warehouse subsector has seen yields decline. The period of yield widening for supermarket property corresponded to a period of intense competition among the supermarket operators, against a background of continuing growth in online retail and its transformational impact on traditional retail distribution.

A more positive trading environment has recently been evident, with the big four showing improved sales trends and margins as they have focused more closely on customer service, diversification of product offering and cost structures. This has been reflected both in positive credit rating changes and improved share price performance. Relative to the FTSE 100 Index, the share prices of Tesco and Sainsbury’s have increased by more than 25% over the past 12 months and that of Morrisons by c 5%.

The investment manager believes that Sainsbury’s proposed acquisition of Asda, currently the subject of a Competition and Markets Authority enquiry, is a positive development, and that consolidation within the operator sector has the potential to further support tenant covenants. It does not anticipate any competition issues with its Sainsbury’s Ashford store, and given that Sainsbury’s and Asda will continue to target a different customer segment, the combined group is expected to retain stores from both brands wherever possible.

Noting the improving performance of the main supermarket operators, the investment manager believes that supermarket property yields offer value and have the potential to tighten (property values increase) relative to other property classes.

One element of the strategic refocus of the big four operators has been a slowdown in large store expansion plans and a consolidation in store numbers, with an effective end to sale and leaseback transactions and a decline in the number of assets being offered to the investment market. Tesco became a net buyer of stores in 2015 and for the first time in many years, there were no new sale and leaseback transactions in 2016 across the market as a whole. Accounting changes (IFRS 16) have encouraged this trend of operator repurchases, often making it advantageous for operators to strengthen their balance sheets by repurchasing property assets and reducing lease commitments. At the same time, some institutional owners of property assets have become more willing sellers, sometimes as a result of more onerous regulatory capital rules that reduce the attraction of their investing in real estate assets, and sometimes as part of an effort to reduce retail property exposure more broadly. Colliers International estimates that investment demand for supermarket assets grew by 18% in 2017, to £1.4bn, driven by operators’ store repurchases and financial investment demand, including overseas investors, perhaps encouraged by the weakness of sterling, and domestic investors, including SUPR. The investment adviser expects this positive investment market to continue, providing scope for yields to tighten and valuations outpace rental growth.

SUPR plans to continue building a diversified portfolio of mainly freehold and long leasehold operational properties, let to UK supermarket operators, and likely to benefit from long-term growing income streams with high-quality tenant covenants. The investment adviser estimates that from a pool of c £20bn of supermarket properties that are not owned directly by operators, c £10bn meet SUPR’s strict selection criteria aimed at assets that can deliver sustainable value in a shifting retail environment. SUPR believes that a portfolio value of c £1bn is a reasonable objective over the long term, or a c 10% share of its target asset pool, compared with c £320m currently. The key elements of SUPR’s investment policy are:

SUPR was able to deploy capital rapidly during FY18, while adhering to its strict investment criteria, and minimising cash drag so as to be able to meet its targets for dividends and dividend cover. The investment adviser’s strong knowledge of the sector and extensive industry contacts were key to achieving this, and all of the acquisitions to date have been off-market transactions. The proceeds from equity issuance, including £100m from the IPO and £85m from the two follow-on equity raises, were invested, alongside leverage, within four weeks or less. Capital deployment, including debt, was achieved in six weeks or less.

A total of five supermarket assets, each combining in-store and online fulfilment, were acquired during the year, and a sixth asset was acquired soon after year-end. The five assets owned at 30 June 2018 were valued at £265m, a 4.1% increase on the aggregate acquisition price (before acquisition costs), with an annualised passing rent of £13.6m, and weighted average unexpired lease term (WAULT) of 19 years. The valuation reflected a net initial yield of 4.9%. The post year-end acquisition of Morrisons, Hillsborough for £51.7m took the annualised passing rent to £16.3m.

All of the acquired assets are subject to RPI-linked rent reviews, in most cases annually, but in the case of Morrisons, Hillsborough, every five years. A summary of the current portfolio is shown in Exhibit 5.

SUPR has developed comprehensive plans for potential asset management projects across all of its sites, aimed at increasing cash yields and, where appropriate, development gains from selective larger projects. Many of the initiatives are relatively small-scale changes and improvements to buildings, requiring limited additional capital spending and/or planning approval, such as investing in green energy schemes that help tenants in meeting their strategic objectives in areas such as sustainability targets. Larger schemes are likely to include repurposing of peripheral space, such as underutilised car parking space, to provide new customer offerings or facilities, potentially enhancing footfall and generating additional income, while enabling the supermarket operators to maximise the value of their buildings.

Many of the potential projects are long term, although the investment adviser expects to proceed with the first larger repurposing schemes over the next couple of years, expecting to invest less than £10m on additional pre-let space to generate a return on development cost of 10-15%.

SUPR will utilise debt in order to enhance returns and target a loan to value ratio (LTV) of 30–40% over the medium term. To part-fund acquisitions, it arranged a £100m revolving credit facility with HSBC in August 2017. The facility has a three-year term with two one-year extension options and pays interest at 1.6% over three-month Libor. To protect against the possibility of interest rate increases, £65m has been hedged with SUPR’s exposure to increases in Libor, on the £65m of hedged debt, capped at a maximum Libor of 1.75% (c 0.80% currently). Above Libor, 1.75% the cost of the hedged amount of debt is effectively fixed at 3.35%. The end-FY18 LTV was 32.4% and SUPR had significant headroom on its debt covenants with an LTV threshold of 60% and 200% interest cover ratio for each asset in the portfolio. The investment adviser calculated that as at 30 June 2018, SUPR could afford to suffer a 30% fall in property values before breaching its LTV covenants and, including its hedging arrangements, had significant interest cover headroom.

Since year-end, SUPR has broadened its banking relationships, adding a £52.1m five-year secured facility with Bayerische Landesbank, at a competitive cost of 1.25% above three-month Libor, secured against the new Morrisons supermarket in Sheffield and the Sainsbury's supermarket in Ashford. The Libor exposure has been fixed at 1.3% for the five years.

Including this facility and taking account of the recent acquisition, net LTV is currently c 43% and the average cost of debt is c 2.4%.

In its first year of trading post-IPO in July 2017, SUPR moved quickly to establish its initial portfolio and a stream of rental income capable of delivering on its dividend targets.

Leaving aside portfolio growth through acquisition, SUPR’s rental income can be expected to increase with RPI, supporting dividend growth and, to the extent that property valuation yields do not change, NAV growth. This is the basis for the company’s medium-term target of 7–10% NAV total return, and is also reflected in near-term earnings consensus, which makes no assumption of further acquisitions although these may be expected. SUPR says that it continues to see multiple opportunities in the market that meet its investment objectives, with the potential to further diversify the portfolio geographically and by tenant covenant.

Current year earnings will benefit from a full-period contribution from the properties acquired during FY18, an almost full-year contribution from the Sheffield store let to Morrisons in July 2018, and annual indexation of rents. FY20 will benefit from ongoing rent indexation.

Administrative costs in the current year will benefit from non-recurring IPO-related costs dropping out, while investment advisor fees will track the growth in average NAV. Interest costs will increase with a full-period impact from the FY18 borrowing, as well as the new £52.1m loan arranged in July 2018, although the average cost of debt will benefit from the attractive pricing on the new loan.

The consensus is for EPRA earnings to increase to £10.2m in FY19 and £10.9m in FY20, with EPRA EPS increasing to 5.5p and then 5.9p.

Consensus forecasts look for EPRA NAV to increase to 100p by end-FY19 and 106p by end FY20. The NAV total return implied by the consensus is 10% in FY19 and 11.9% in FY20.

To better illustrate the potential impact of contractual RPI rent uplifts on rental income growth, SUPR has provided the data in Exhibit 10. The illustrated growth in rental income in FY19 includes the £2.54m July 2018 addition of the Sheffield asset let to Morrisons. Otherwise, the rental growth reflects RPI growth of 3.2%.

With the illustrated growth in rents, the yield on property purchase values also increases. However, if we assume no change in property valuation yields, the external market valuations of the properties would be expected to increase further. We estimate that applying an unchanged 4.9% valuation yield to the illustrated FY23 rental income implies c £58m potential upside to the £330 historical purchase price, or c 31p per share.

As noted above, the investment adviser believes that there is scope for supermarket property yields to reduce, relative to other classes of commercial property potentially in absolute terms, with a positive effect on supermarket property valuations.

SUPR’s long-term leases and RPI-linked rent growth provide investors with considerably visibility over a growing stream of contracted rental income, and offer considerable protection against inflation. The company’s current-year target of fully covered dividends of 5.63p puts the shares on a prospective FY19 dividend yield of 5.5%, ahead of the median 4.6% yield on the broad range of property companies and REITs shown in Exhibit 11, and with visible potential for dividend growth.

Reflecting investor demand for companies that offer secure long-term income, within a range of UK commercial property stocks, SUPR trades at a c 10% premium to the median P/NAV which is c 0.95x (Exhibit 12).

Despite the above median P/NAV, the prospective dividend yield is also above median, reflecting SUPR’s strong income focus.

In Exhibit 13, we show the key valuation and performance metrics for SUPR and a more focused group of companies that similarly target long-lease exposures across a range of property types including healthcare property, ‘big box’ distribution centres and leisure assets. Compared with this group, SUPR offers a yield that is above the median for a broadly similar P/NAV.

Although all of the companies listed in Exhibit 13 have WAULTs that are above the average of the broad property sector, there remains a considerable variation within the group. Among these, the WAULTs for the primary care asset investors are on average shorter, and although upwards-only, a significant share of the leases are subject to open market review rather than being indexed. However, the vast majority of leases benefit from significant direct or indirect (through general practitioner reimbursement) government backing. Lease terms for the other companies are predominantly index-linked, with tenant exposures being mostly corporate, across a range of sectors. As noted above, the investment adviser believes the implied risk premium attached to large supermarket group tenants is attractively wide compared with negative real yields on UK-index linked gilts, and that there is potential for this to narrow in line with improved supermarket operator performance.

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