Yet another new property backed income fund — this time supermarkets!

Another day, another listed fund comes to the London market, offering up an alternative form of asset backed income. This one is arguably the easiest to understand as it is the Supermarket Income REIT. You guessed it, they’re buying supermarkets, on long, inflation backed leases to big blue chip clients.

This isn’t a new idea. Target in the US backed out its supermarket assets into a REIT and every once in a while an activist investor in the big grocery chains mutters darkly about reversing out the supermarket assets.

Crucially also this passes another key test — alternative land use. My worry with some specialist, niche property assets such as big logistics boxes is what happens when demand from the primary target market dries up ? For supermarkets there’s a multitude of alternative uses, not least residential (including in the space above units).

My worry is how the fund is actually generating the promised dividend which will eventually be 5.5%. The underlying assets generate a net yield — we are told — of 4.9%. As you would expect there is leverage here, which will range between 30 and 60%. Assuming that the cost of that debt is a reasonable 1.5% to 3% (good blue chip clients after all), and that the overall costs of the fund will probably be a smidgen over 1% (the initial AMC is 0.95%), then I struggle to see how we get to a fund distribution yield of 5.5% without eating into capital. Here’s my maths. assume £200m is raised and 30% leverage deployed. Actual property of £285m is bought on 4.9%. That generates a rental roll of £14m. The fund might also pay say 2% on the £85m of leverage, equating to an interest bill of £1.7m. The fund will also probably have costs of say 1% to 1.25% including management fee, which equates to another £2m. Last but by no means least we also have that dividend payout of £11m a year. So dividends, plus costs plus interest adds up to £14.7m, which is more than the rent roll ?These maths also don’t allow for the fund to build up a distributable reserve for rainy days (say £1 or £2m a year).

UPDATE – Having talked to the managers I am a little clearer on the economics. Gearing looks like it will be at 40% and crucially the funds AMC is only charged on equity not debt. So assume £333m of total assets and £200m of equity. Debt will probably cost around 2% pa implying £2.7m interest bill and 1.25% total fund fees on £200m in equity, implying £2.5m. The 5.5% dividend still costs £11m implying total cash outflows of around £16.2m. Cash income is 4.9% of £333m which equals £16.2m. In addition rents are due three months in advance which gives you some cash freefloat. And the contracts are inflation linked which also implies some upside in rents. One other point from the managers. The average leases of 17 years CANNOT be broken – they are fixed.

So despite my initial worry about the maths, this does look like an interesting play with the two obvious caveats. The first is that over the long term these big retail boxes on the outskirts of towns might fall decisively out of favour especially as energy infrastructure and planning changes. Already we’re seeing in the US the increasingly rapid decline of bug shopping malls in the wrong places. Yields are falling and tenants fleeing. These big structural shifts could cause major problems for a supermarket portfolio.

The other obvious comment is that yet again we’re seeing embedded leverage as the core part of total return. in property that is of course par for the course but these kind of funds are locking in low rates into financial structures to leverage up returns. That is all fine and dandy as long as interest rates stay low — which I think they will for a very long time — but the risks are obvious.

The fund will be managed by Atrato Capital. According to Numis the team has structured and executed over £3.5bn of supermarket sale and leasebacks over the last 10 years. Fees will be 0.95% pa of NAV (less any uninvested cash) up to £500m, 0.75% up to £1bn, 0.65% up to £1.5bn and 0.45% thereafter. 25% of the management fees will be paid in shares, and there is no performance fee. The Directors (fully independent) and the Investment Manager intend to invest £1.3m in the issue.

Here’s the summary from the funds PR house about the launch:

The fund is aiming to raise £200 million, through Stifel Nicolaus Europe, to buy supermarket freeholds — mostly, let to Tesco, Sainsbury’s, Asda and Morrisons.

The timing is interesting, coming after Amazon’s acquisition of Whole Foods, which shows that physical stores are as important as online for grocery sales. Online is great for books, tablets and toys, but online is not great for low cost, low margin, perishable groceries.

The key points are:

  • The company has lined up £263 million of acquisitions (Tesco and Sainsbury’s stores) at a net initial yield of 4.9%. Supermarket yields have risen over recent years and the sector has been largely unloved, but If Amazon wants UK stores, then that could lead to some repricing.
  • The company to targeting an initial dividend yield of 5.5%, which will then grow progressively — RPI. It intends to declare its first quarterly dividend in October 2017.
  • The company is externally managed by Atrato Capital, which has been set up by Ben Green and Steve Windsor, who at Goldman Sachs structured and executed £3.5 billion of supermarket sale and leasebacks over the last 10 years.
  • The chairman is Nick Hewson, who co-founded (and was CEO) of Grantchester, the retail park specialist, with Paul Whight.