The ability to provide long-term, secure income has caused supermarkets to behave differently to the rest of the UK retail sector, says Greg Mansell
Despite profit warnings and food scandals, supermarkets as investments have gone from strength to strength over the last five years.
Net investment volumes have been positive for 14 consecutive quarters and returns have been robust, due not only to the inevitable yield compression from weight of capital, but because of a healthy occupier market, which has supported rental value growth despite the recession.
Supermarkets’ credentials as a safe asset class are clear: 58 pence in every retail £1 spent is now in a supermarket, according to the latest payment council report, up from 46 pence a decade ago. Three of the ‘big four’ brands (Asda, Morrisons, Tesco and Sainsbury’s) are in the top 10 of the most secure tenants in the IPD Rental Information Service.
To breakdown further: every tenant in our databank is matched with a corresponding D&B tenant failure score, where the safest tenants can be awarded a maximum score of 100. UK commercial property averaged a score of 79 last year, whereas supermarkets achieved an average of 96.
Complementing strong covenants, supermarkets offer increasingly scarce longer leases. Unexpired lease terms for all UK commercial property have fallen to just 10 years, while for supermarkets they are over 19 years.
Lease length, in particular, has been a significant differentiator of performance over the last five years. Long-let assets have outperformed short-let in both the downturn and the recovery. Even long-let secondary properties have outperformed short-let prime in each of the last five years, as shown by our own analysis on the IPD UK Quarterly Property Index.
Contrary to conventional wisdom, it has not been all about prime assets; it has been about prime income. Income security has taken precedent over asset quality and supermarkets have offered this in spades.
Traditional property sectors, such as high-street shops, offices and industrial units, have struggled to offer the longevity of income they once achieved.
As a result, the yield premiums required to compensate for such leases are excessive, and with each passing year asset managers face an increasingly uphill struggle to counteract such movements.
Supermarkets do not suffer such hardships
The additional advantage of so much of the asset’s present value being tied up in the
lease means there is less emphasis on the asset itself. It would be dangerous to suggest that the location and physical attributes of the asset are not important, but the fact remains that supermarkets have performed in a homogeneous fashion thanks to long leases and uniform covenants.
Smaller stores generated returns of 5.8% in 2012, while larger assets returned 5.9%. Geographically, the South East returned 6.2%, while the rest of the UK returned 6.1%.
The typical London-versus-the-rest and large-versus-small trends seen in the wider market have not applied. Supermarkets have delivered predictable returns, with limited tail risk.
Even though supermarkets form a small sub-market, currently totalling around £5bn of the £51bn UK retail sector, the vast majority of assets behind that figure have been performing well.
Subsequently, it is on the radar of new investors, and the growing demand for a true defensive asset has benefitted from the increase of sale-and-leaseback deals offered by operators keen to expand.
Investors are starting to split into two groups. The first small but growing group is starting to look at high-yielding regional assets. At the end of 2006, average initial yields for the retail sector were just 4.3%. Now, the average yield is 6% and is considerably higher outside London. Moving up the risk curve may finally start to pay after such a long re-pricing phase.
But the majority of investors, still firmly in risk-off mode, will ensure that defensive, long-income options like supermarkets and other alternate property assets will remain in high demand.
While the UK economy continues to disappoint, long-income assets will remain popular, despite the aggressive pricing. High unemployment, particularly in the regions, has stifled any chance of sustained demand growth, keeping vacancies high and rental value growth negative or weak at best.
Furthermore, property yields remain at a comfortable premium to gilts. Moody’s downgrade of the UK government’s bond ratings had little effect on yields, with the markets seemingly interpreting the move as a vote for a weaker economic outlook rather than an increase in sovereign risk. Yields actually fell from 2.2% to 1.9% in its wake.
A weak economic outlook plays to the strengths of supermarkets, but even the early stages of an economic recovery would be unlikely to deter further investment.
While more volatile ‘safe havens,’ for example, London offices, might struggle to justify their low yielding status, supermarkets have the unique benefit of being a true diversifier for a balanced portfolio, with rents, covenants and leases opposing the trends seen in the wider market.
A market segment that can reduce portfolio risk and boost returns has been a rare find and investors are unlikely to turn their back on such an opportunity anytime soon.
Greg Mansell is head of research for the UK & Ireland at Investment Property Databank