On the face of it, 2023 saw strong transactional volumes in the grocery sector, with approximately £2.5bn transacted during the calendar year, vs the 10-year average of c. £1.8bn. Dig a little deeper, however, and this headline figure was dominated by a handful of large-scale sale and leaseback / corporate deals, with conventional investment transactions during the year comprising less than £1.5bn.
In the more conventional segment of the market, meanwhile, 2022’s theme of a lack of supermarket investment stock continued, despite continued investor demand from REITs, Private Equity, Institutions, Prop Cos and High Net Worth Capital (domestic and overseas) alike.
A DIVERGING MARKET
The covenant strength of the Big Four grocery retailers remains polarised, with a step-change in market pricing between Tesco and Sainsbury’s compared to Asda and Morrisons owing to the debt burden of the latter two. Aldi and Lidl remain sought-after covenants, although Lidl has scaled back expansion plans for the short to medium term while Aldi continues its store expansion at a rapid rate.
We have also seen the investor base for supermarkets diverge, with traditional DC pension funds and specialist investors focussing on assets at the prime end of the market, whilst PE, REITs and Prop Cos are typically seeking higher yielding opportunities – therefore often focussed on stores with shorter leases and over-renting, but where trade is strong.
YIELD COMPRESSION UNDERWAY
Continued investor demand for supermarkets has begun to lead to yield compression in the order of 25-50 basis points during the first quarter of 2024. Unlike other property sectors – this is true of both the prime and secondary tiers of the investment market.
And despite economic and geopolitical headwinds remaining, we have seen increased investor competition for foodstore assets to ensure they do not miss the current buying window. At the same time, with grocery retail property continuing to appear undervalued, most investors are anticipating further yield compression again during the second half of the year.
Prime foodstore yields (rack rented, 15-20 years, rental indexation) currently sit in the 5% territory, significantly out from their sub 4% in peak in early 2022. At the height of the market, over-renting presented much less of an issue than it does in today’s investment market and even stores with shorter leases and rents into the £30s psf were trading well into the 4%s NIY, compared to 7%+ NIY today.
FUTURE REGEARS
Over-renting is a common theme in the supermarket sector, particularly large format superstores, with many let off long, index-linked leases, meaning passing rents commonly escalate to 50%+ ahead of market ERV.
For strong trading stores, rents at these levels can still be perfectly comfortable and profitable, remaining in the region of 4%-6% of store turnover and evidencing the immense trading opportunity that the best sites provide.
Over the medium term we expect an increased number of supermarket re-gears where rents are reduced, but not reduced all the way to ERV. For the grocers, this means a significant day one rent reduction as well as, perhaps more importantly, ensuring they secure the future of their best sites in the long term. For landlords, re-gears can clearly mean value enhancement, increased income security and improved asset liquidity.
But for weaker trading superstores and/or locations where the remainder of the Big Four are located in close proximity to the subject, the shelves are stacked in favour of the tenant and will mean more occupier-friendly outcomes at lease re-gear / renewal.
FALLING INFLATION
In addition to pricing and anticipated further yield compression, another investment case for foodstores at the present time is easing supply-side pressures for retailers. Grocery price inflation has fallen rapidly from recent highs, and wage growth is anticipated to fall with reduced inflation. This is likely to positively affect store effort ratios and affordability margins, which in turn should strengthen retailer balance sheets.
STOCK SELECTION
Characteristics including omnichannel capability, location, car parking, access, store configuration, catchment size and affluence and increasingly, tenant covenant and sustainability metrics remain important factors for investor shopping lists. However, an understanding of trading performance and competition metrics remain the key for both stock selection right now and asset performance over the longer term.
BUYING WINDOW STILL OPEN
Whilst we have seen pricing begin to improve in the supermarket sector, we expect further yield compression throughout the second half of the year. Now remains an opportune time to invest in the supermarket sector, with investors able to pick up top trading stores at pricing below long term average values.
