Superstores: Is big really beautiful in the new normal?

Supermarkets have been among the undisputed winners in the pandemic but as the country recovers and a ‘new normal’ emerges, there is a question in property circles over whether the largest superstores can continue to deliver the goods.

With government-enforced lockdowns putting an end to eating out, a surge of panic-buying, soaring online shopping and a lack of other retailers to visit meant ‘essential retailers’ like supermarkets saw sales – and costs due to social distancing restrictions – boom during the Covid-19 outbreak.

Figures from estate agent Savills show take-home grocery sales rose 11.3% in the 12 weeks to 29 November, as Brits dealt with the second of three nationwide lockdowns.

Supermarket Income (SUPR), the 5%-yielding real estate investment trust (Reit) focused on buying large, well-located stores with long-term leases to Tesco, Morrisons, and Sainsbury’s, has been a beneficiary of the pandemic as well.

The trust has almost doubled in size over the past year through share issuance to satisfy demand from investors. Their search for steady, reliable income has been rewarded as SUPR has collected all its rent and, with its shares trading at a 12% premium over net asset value (NAV), has hit a market value approaching £1bn.

However, there are some fund managers who aren’t convinced that this good news story can continue and are instead shunning the large stores beloved by SUPR in favour of smaller, more local grocery outlets.

Simon Lee, manager of LXI Reit (LXI), said food stores and essential retailers make up 26% of the rental value of his £858m fund that currently yields 4%.

His tenant roster includes discount supermarkets Lidl and Aldi, as well as Sainsbury’s, Co-op, and Waitrose, but he is steering clear of large superstores.

Lee has seen ‘increased investor demand’ for UK food stores which has lifted the value of his assets and he said the sector as a whole has ‘benefited from increased local spend’ during lockdown as people were reluctant to travel too far.

However, he believes the trend towards local shopping will continue as people continue working from home.

‘This supports our strategy of focusing on growth sub-sectors, including convenience stores and the discounters, and in small and mid-sized stores of 20,000 to 40,000 square feet, all of which are omni-channel connected,’ he said.

‘For quite a number of years now, you’ve rarely seen the big four grocers building larger format supermarkets, partly because much of the floor space that was dedicated to, for instance, white goods isn’t needed as that’s mostly gone online.’

Atrato Capital’s Ben Green, who manages Supermarket Income Reit, said he has been ‘very lucky to be in the right place at the right time’ over the past year but he doesn’t believe the pandemic has called time on the largest supermarket stores.

While Green concedes that the big grocers no longer need space to show and store bulky white goods that are now sold online, he said the boom in online grocery shopping means the extra space is not going to waste.

Data from Atrato shows Tesco increased the number of weekly delivery slots by 150% to 1.5m in the year to 31 March, while Asda increased its weekly deliveries by 89%, Sainsbury’s deliveries grew 126%, as did Waitrose 126%, while Ocado’s rose 50% during the pandemic.

The increasing trend for online food shopping is expected to remain after the health emergency and Green believes supermarkets will continue to need large spaces to service the demand.

Green said for some supermarkets it is ‘absolutely mission critical to grow and they do need space’.

‘They may need less space for shopping in person but they will need big sites as there is a big opportunity to service the online demand,’ he said.

‘Online demand doubled for groceries in the past 12 months but overall shopping is up 12% so if you own stores that are not doing online then you are losing market share. [The ones servicing online] are the ones we invest in, and we are comfortable that we are picking the right ones.’

Green said supermarkets want to get to the point where they are ‘agnostic to which channel customers shop in’, whether that be in-store, home delivery, or click and collect.

The Atrato manager said large superstores will in future offer groceries, clothing, and some homewares, but an increasing amount of space will be given over to behind-the-scenes online ordering.

‘More and more space will be taken over by picking [for online groceries] and I think in the future the space [that is no longer needed for bulky goods which are sold online] will be used for automation for picking online orders,’ he said.

Green added that Tesco already describes these areas as ‘urban fulfilment centres’ and said it was akin to the Ocado model of a large warehouse where inventory is packed on receipt of an online order.

‘It is Ocado-lite technology in the supermarket itself,’ he said. ‘The great thing about large supermarkets is they are built within a 15-to-20 minute drive time to customers and that is perfect for delivering orders back out,’ he said.

Supermarkets without large bases near their customers then have to drive orders further and Green said this ‘kills the economics’ of online shopping.

Calum Bruce, manager of the £143m Ediston Property Investment Company (EPIC), recently sold his only large-sized supermarket of 65,000 square feet to Supermarket Income, as he said a report by Savills found the ‘optimal size’ for a supermarket to trade a full range of goods was ‘below the typical size of the larger supermarkets’.

Like Lee, Bruce focuses on smaller supermarket assets, and has just signed a deal with Aldi for a 19,000 square feet shop, which he said is ‘the ideal size’ for his portfolio.

Another of EPIC’s food-related tenants is Marks & Spencer, which Bruce said was one of the most acquisitive retailers last year in the search for more Simply Food outlets.

He said he sold the large supermarket at a 5.2% yield but could redeploy the cash to gain a rental income of ‘7%-plus’ by buying stores which can benefit from ‘active management’ that can ‘make the capital work as effectively as possible’.

Bruce’s Reit trades on a wide 19% discount and a high 7.4% yield after the NAV declined an estimated 7% over the past year, although the shares have bounced back from the pandemic lows, adding 49.5% over the past 12 months.

LXI’s Lee said one of his trust’s strategies is to forward fund pre-let assets in smaller lot sizes, which he said is ‘a less competitive market’.

‘Our strategy delivers more attractive entry yields, brand new fit for purpose, sustainable state-of-the-art buildings, and rents set at the market level,’ he said.

‘Our average rent in the food stores and essentials sector is a low £14.58 per square foot, a level that you don’t come close to in the older, larger formats. The average net initial yield we’ve achieved on acquiring food stores and essentials to date is 5.4%, which compares favourably to the yields on larger format supermarkets.’

LXI shares have provided a total return of 35% over the past year while its NAV has risen 5.7%, leaving it trading at a premium of 15%. Food stores have been the sector of biggest outperformance but Lee said it is not just discounters boosting returns but also a move into smaller convenience stores.

‘The pandemic has further enhanced the profitability of local shops like Co-op and what we have seen is that the covenants are very strong, the leases are getting longer, and there is yield advantage as we are buying at 6% yield,’ he said.

He added that smaller stores did not fit with the strategies of the likes of SUPR who want to ‘tuck away £50m’ in a deal, as Lidl and Aldi stores average around £8-10m in price and Co-op stores are around £2-3m.

‘It’s pretty hard work [investing in multiple small deals] and it is grinding but that’s how we get upside. We will continue to do forward funding across the piece as that has also given us really good uplift,’ said Lee.

By opting for smaller stores, Lee said he avoids the larger institutional investors who are trying to break into the popular asset class and who are driving down yields and driving up prices.

He sold a Lidl in a south-east location for a yield of 3.5% but said he was buying at 5% yield – ‘that’s a hell of a discount’.

‘We will probably see more yield compression,’ pushing up the price of properties, he said.

Although Green said he could see why other fund managers believe big superstores aren’t appealing anymore, he warned that discounters such as Aldi and Lidl are losing market share because of their lack of online presence – with the losses particularly stark during the pandemic.

‘Aldi is experimenting with click and collect but they don’t really have enough space [in their stores],’ he said. ‘There is tonnes of space around big stores that can deal with lots of traffic for deliveries.’

While Green said there will be some stores that need less space in future, he is not about to change his strategy now.

‘Supermarkets are an investment asset class that has become, unsurprisingly, much more popular as a result of what happened over the past year,’ he said.

‘We have a massive information advantage and we know the assets and whether we can continue to buy at levels that are attractive to shareholders, and we think we can.’

Green is confident about growing the market capitalisation of the fund to the £1bn mark.

‘It feels like the shares are still cheap and we could get there on share price alone without the need to raise money, but if we find an acquisition we like then we will come back to market.’