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Supermarket Income remains good value

The landlord has continued to grow well despite increasing competition for supermarket assets
July 14, 2022

Cast your eyes over pictures of the first British supermarkets from 70 years ago, and the grainy black and white images at first seem to depict a quaint past with little resemblance to our current shopping habits. But look closer. Rows of pre-packaged food are laid out in aisles, filled with shoppers carrying baskets of products they will take to the tills to pay for. This pretty much remains the layout and function of the British supermarket today. Although appetites have changed with wider product ranges, the core concept has barely changed since it was imported from the US in the 1950s.

IC TIP: Buy
Tip style
Growth
Risk rating
Medium
Timescale
Medium Term
Bull points
  • Long-term, stable rent roll
  • Rising annual dividend payments
  • Growing asset portfolio
  • Discount to forward NAV
Bear points
  • Leases come with inflation cap
  • Concentrated tenant exposure

For Supermarket Income (SUPR), which owns or jointly-owns 69 supermarkets across the country, the largely unchanging nature of its tenants’ business is central to its investment case. The real estate investment trust (Reit) argues that the income that comes from facilitating such a consistent business model offers long-term protection from inflation, backed by some of the safest tenants a landlord could ask for: Tesco (TSCO)Sainsbury’s (SBRY), Morrisons, Asda, Aldi, Waitrose and Marks & Spencer (MKS).

The largest supermarket chains are big enough to own their properties, rather than rent them. And many did used to do so in significant numbers. But starting around 20 years ago, some started to sell off and then rent back their real estate assets as a way of releasing cash for other capital spending. Between 2004 and 2011, Tesco alone generated £5.5bn from these sale-and-leaseback deals.

But what is a balance sheet exercise for the supermarkets is Supermarket Income’s lifeblood. While many Reits look to purchase or develop assets to let them to new tenants, Supermarket Income buys existing supermarkets which are already on long leases. The average unexpired lease term for the assets it owns directly is 15 years and its leases are linked to inflation with a 4 per cent cap and collar. Ordinarily – that is, when inflation isn’t tracking in double figures – this lease clause is more than enough to preserve rental income values. Management will hope widespread price rises soften in the coming year.

However, Supermarket Income’s asset focus isn’t confined to lease length. Rather, it targets supermarkets it perceives as well located both as hubs for online shopping delivery and for offline shopping – factors which would allow the asset to be easily re-let if the need arose.

Seeking security in the demand for a commercial property might sound like an obvious point. But it is not a given that landlords focused on long leases can easily identify re-letting opportunities to anyone else other than their existing tenant. Take Secure Income (SIR), for example. It owns Thorpe Park, Alton Towers and Heide Park in Germany, which are leased to operator Merlin Entertainments for the next 55 years. While this income might look guaranteed on paper, the landlord would be left with three enormous headaches if for whatever reason Merlin failed to pay its rent, or people stopped going to theme parks.

Equally, Covid has shown that, in extreme circumstances, some struggling commercial tenants can and do refuse to meet the contractual and legal obligations of their leases. Were Tesco, Sainsbury’s, Asda or Morrisons to do that, Supermarket Income would still own their supermarkets. And because of the largely unchanging nature of supermarket design, a vacant Woolworths can become an Asda and a vacant Safeway can become a Morrisons. A vacant Thorpe Park, by contrast, would likely prove trickier to re-fit.

 

Supermarket sweep

Supermarket Income’s model has allowed it to grow during a tumultuous two years for many retail-focused property companies. Back in February 2020, just before the pandemic turned the world upside down, we made the case for the shares at 108p. Despite an initial hit, the stock has since produced a total return of 24 per cent and has been one of the few listed property groups whose value has increased in 2022. All of this means the company trades at a premium to its last audited net tangible asset value (see table), but we feel this represents good value considering its sound financial position and growth options. The group’s board clearly agrees, given four directors snapped up £570,000-worh of shares last week.

The big question for investors is whether the company can continue to grow at the pace it has set. The Reit has amassed a £1.6bn portfolio of assets since it began trading in 2017 and sees plenty of opportunity to buy more sites given consistently high transactional activity in the sector. In every year since 2010, agency Colliers calculates that investors have traded at least £1bn in supermarket assets, with 2021’s tally of £1.85bn marking a record.

Investors wary about the rising cost of capital and what this might do to growth should bear in mind compression of the supermarket sector’s yields – a figure which expresses the annual rental income of a property as a percentage of its value. According to research from Supermarket Income’s investment adviser Atrato Capital, the average yield for transactions in the sector has fallen from 5.3 per cent in 2016 to less than 4.5 per cent in 2021, meaning investors such as Supermarket Income are having to work harder to boost their cash returns on capital employed. This is something the Reit’s manager is acutely aware of, although it is worth noting that falling yields are also a sign of the increased asset values.

However, there is some indication that the trend can be bucked. Last week, the Reit bought a Tesco superstore, M&S Foodhall and an Iceland in Basingstoke as well as an Asda supermarket in Doncaster, for just shy of £83mn, reflecting a combined net initial yield of 4.9 per cent. Should Supermarket Income want to buy more high-yielding assets going forward, it will likely look to acquire some Asda supermarkets, which Atrato Capital calculates could trade at an average 5.7 per cent yield, compared with Tesco’s 3 per cent and Sainsbury’s 2.3 per cent.

Keen values in the Sainsbury’s estate are reflected in the success of a joint venture the Reit entered with British Airways’ pension scheme to acquire 26 sites from the supermarket. Since signing the deal, the joint venture has resulted in a £60mn gain thanks to a mixture of yield compression, ongoing rental income and Sainsbury’s exercising an option to buy back 21 of the stores at a £30mn mark up.

Asda, which was taken private by the Issa brothers last year, will no doubt assuage Supermarket Income in its appetite for freeholds. However, any deal could come with extra risks given the heavy use of leverage in the takeover. The wisdom of this decision is something for Asda to worry about rather than Supermarket Income, which currently owns just two Asda outlets. Yet, when a landlord is so dependent on a few tenants, the ability of its counterparties to honour long leases should command investors’ attention.

 

In the medium term, shareholders can place some faith in Supermarket Income’s strong track record of quality asset purchases, implying it will continue to shop wisely in the future.

Company DetailsNameMkt CapPrice52-Wk Hi/Lo
Supermarket Income REIT  (SUPR)£1.53bn123p135p / 115p
Size/DebtNAV per share*Net Cash / Debt(-)Gearing5yr NAVps CAGR
113p-£454m41%4.2%
ValuationDisc/Prem Fwd NAV (+12mths)Fwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)
-1%214.9%-
Forecasts/ MomentumFwd NAV grth NTMFwd NAV grth STM3-mth Mom3-mth Fwd NAV change%
 5%5%-1.2%4.6%
Year End 30 JunNAV per share (p)Profit before tax (£mn)EPS (p)DPS (p)
20199410.04.905.48
20209924.84.905.68
202110545.15.485.78
Forecast 202211871.95.515.93
Forecast 202312486.75.916.08
Change (%)+5+21+7+3
Source: FactSet, adjusted PTP and EPS figures
NTM = Next 12 months
STM = Second 12 months (ie, one year from now)
*EPRA NTA as at 31 Dec 2021.