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Supermarket Income REIT
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== Strong near-term returns with a positive outlook == The H122 results showed a strong financial performance, boosted by accretive acquisitions, rental growth and revaluation gains. The prospects for a continuation of these trends are favourable. SUPR identifies three key structural factors that currently underpin this positive outlook, namely: the trend to working from home, which continues to favour grocery spending at the expense of restaurants and bars; positive inflationary tailwinds that drive rental growth and support the performance of operators; and digital transformation, increasing the market share of the omnichannel stores on which SUPR is focused. We explore each of these below. Income visibility and security continues generate strong investor demand for supermarket properties, 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 in combination with its sector expertise and intelligence to support continuing accretive acquisition led growth. The proceeds of October’s £200m (gross) equity raise were deployed within three months and, including subsequent transactions, SUPR has now deployed £277m, with the acquisitions of six supermarket assets. Debt funding capacity remains for further acquisitions and the distribution of cash from SUPR’s highly successful indirect investment in the Sainsbury’s Reversion Portfolio (described in detail below) in the middle of calendar 2023 will release significant cash (we estimate £184m) 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. The post-H122 entry into the Premium Segment of the LSE and the attainment of an Investment Grade credit rating are strategic milestones, providing access to a wider base of potential equity investors and adding increased debt funding flexibility. Both will further support inorganic portfolio growth from a continuing strong pipeline of identified opportunities. '''The shift to working from home and increased digitalisation''' Increased working from home appears likely to remain a permanent feature even as the economy fully re-opens and represents a step-change in UK grocery shopping habits. During the pandemic, supermarkets demonstrated their critical role in the UK economy as core food infrastructure and although the exceptional growth experienced during the lockdowns has normalised, grocery sales remain 10% higher than pre-pandemic levels, in part due to the shift towards working from home resulting in a more permanent increase in household spend on groceries. While in-store shopping remains the dominant channel, representing 87% of all grocery sales<ref>Kantar data.</ref>, the 13% share of online sales is almost twice the pre-pandemic level. Omnichannel stores have captured an outsized share of the growth with 80% of all UK online orders fulfilled from a store. Omnichannel stores with in-store picking for online orders are capital light, flexible and quickly scalable, and have now become a profitable method of fulfilling online orders. The online channel shift has been dominated by the major supermarket operators (68% market share) leveraging their store networks to support last mile delivery. '''Inflation benefits''' Given the non-discretionary nature of most grocery sales, supermarkets have historically benefited from an inflationary environment, with their ability to pass on supply chain cost pressures through price increases. In February 2022, the 12-month rate of RPI was 7.1%, the highest rate of increase since March 1991, while CPI increased by 5.5%, the highest rate of increase since March 1992. The Bank of England continues to expect a moderation in inflation as commodity prices stabilise, supply shortages ease and global demand rebalances, but this is far from assured, and has surely been deferred by the continued rise in oil and commodity prices amid international tensions and war in Ukraine. SUPR benefits in two ways from this inflationary tailwind. The first is through the inflation-linked rental uplifts that apply to 85% (76% RPI and 9% CPI) of passing rent, although this is capped at an average c 4%. The second is from the beneficial impact that may be expected on operators including the linkage between store turnover and the determination of market level rents. SUPR estimates that its average rent to turnover ratio across the portfolio is c 4%<ref>Based on Atrato Capital estimates of store trading.</ref>, which it believes indicates that rents remain highly affordable. '''Premium Segment listing''' SUPR’s migration from the specialist fund segment to a Premium Segment listing on the Main Market of the London Stock Exchange is likely to benefit the company and existing shareholders, including the increased liquidity that should arise from the likely inclusion in the FTSE 250 and FTSE EPRA NAREIT stock indices, including demand from passive and tracker investment funds. The cut-off date for the next quarterly rebalancing of the FTSE 250 Index is 20 May 2022, and the next FTSE EPRA NAREIT quarterly index review will be published on 3 June 2022. '''Investment Grade credit rating''' The Investment Grade credit rating of BBB+ (stable outlook) awarded by Fitch Ratings provides SUPR with increased debt-funding flexibility and the opportunity to pursue a wider range of debt funding strategies. This includes the potential for accessing the sterling bond market, providing access to longer-term unsecured funding. '''Good potential for further yield compression''' 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, yields for the assets that SUPR targets have compressed from c 5–6% at IPO in July 2017 to c 4.4% currently, and this has been reflected in the valuation of SUPR’s portfolio3 and NAV. SUPR’s portfolio is currently valued at a 4.7%, yield which it believes reflects a conservative approach by valuers, yet to fully reflect investment market activity, particularly for the omnichannel stores4 that it targets. SUPR firmly believes there is further valuation upside in its portfolio from yield compression. Yield compression has largely 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. Over the past three years, c £5bn of UK supermarket properties have transacted. 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. SUPR anticipates further market yield tightening, driven by transaction activity but also by a positive valuation relative to bonds. Tesco and Sainsbury’s unsecured bonds trade at a significantly tighter yield than supermarket property5 despite the latter getting the benefit of inflationary rent uplifts. Asda bonds trade at a wider yield6 and SUPR sees potential for selective sale and leaseback transactions. The spread between UK supermarket property yields and UK index-linked gilts is close to an all-time high and although SUPR’s index-linked rent uplifts are capped at an average c 4%, this is in alignment with the longer-term inflation outlook implied by market pricing. Despite yield compression, SUPR sees further potential for accretive acquisition-led growth using what it believes to be its information and relationship advantage. This may give it an insight into store trading and help it to identify those stores that are strategically important to the operators, supporting its ability to source attractive stores from the very large volume of market transactions. '''Swift capital deployment and further opportunities''' SUPR has built a 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. The deployment of the proceeds of the most recent £200m (gross) equity raise in October was in line with this trend. By late December 2021, £222m had been committed to four acquisitions, with final completion in early January 2022. Including the subsequent acquisition of an additional two stores, SUPR has now deployed £277m at an average 4.6% net initial yield. In October, SUPR disclosed an identified pipeline of identified acquisition opportunities of more than £600m but our forecasts include little of this. We assume additional acquisitions of £22m by end-FY22 and a further £300m (before costs) in FY24 as the cash proceeds from the joint venture (JV) (explained below) are redeployed on a geared basis.
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