Fitch Ratings has affirmed Supermarket Income REIT plc's (SUPR) Long-Term Issuer Default Rating (IDR) at 'BBB+' with a Stable Outlook.

SUPR's rating reflects the group's growing GBP1.8 billion all-UK supermarket portfolio as at end-2QFY23 (financial year-end June) focused on large superstores dominant in their catchment and offering omnichannel positioning (in-store sales operating side-by-side with online deliveries and click-and-collect services). The portfolio's leases are predominantly inflation-linked defensive income streams and benefit from exposure to a growing, essential-service, UK grocery sector.

The rating is constrained by an inherent lack of portfolio diversity and high tenant concentration, which reflects the UK grocery sector's small number of large dominant operators.

SUPR's financial profile is in line with its long-term policy's loan-to-value (LTV) range of 30%-40% translating into net debt/EBITDA of 8.0x-9.0x and interest coverage above 5.5x.

Key Rating Drivers

Long-Term Leases; Inflation-Linked Rental Uplifts: The rating is supported by the portfolio's long weighted average unexpired lease term (WAULT) of 15 years. This is typical of UK supermarket properties with individual leases of 15 - 25 years. About 82% of the portfolio has RPI/CPI or fixed annual or five-yearly upward-only rent reviews capped at around 4%, resulting in defensive, predictable income streams. The rest of the portfolio has open-market rent reviews, which are held on a five-yearly upward-only basis.

High-Quality but Concentrated Tenant Base: As at end-2QFY23, SUPR directly owned 50 predominantly omnichannel fulfilment stores. The portfolio is concentrated around the UK's two largest traditional grocers - Tesco PLC (BBB-/Stable; 50% of the rent roll) and Sainsbury's (32%). Morrisons (Market Holdco 3 Limited B+/Stable,), ASDA (Bellis Finco plc BB-/Negative), new generation discounters Aldi & Iceland, each occupy less than 10% of SUPR's rent roll. Notwithstanding tenant concentration, the portfolio is geographically dispersed across the UK, and no single asset represents more than 5% of total gross asset value.

Robust UK Grocery Market: UK grocery market sales grew by CAGR 3.6% during 2015 - 2020. Despite coming off a pandemic recovery-driven revenue growth in 2020 of 8.4%, in 2021 the UK grocery sector still grew 0.3%. Driven by inflation, year-on-year food and grocery revenue growth in December 2022 was 9.4% (with sales that month breaching GBP12 billion for the first time). SUPR's focused portfolio of supermarkets captures the omnichannel fulfilment stores that form 30%- 40% of Tesco/Sainsbury stores.

Omnichannel Fulfilment Supermarkets Dominant: SUPR's portfolio is focused on omnichannel fulfilment stores (93% of portfolio value), which optimise operational synergies of all three channels (in-store, click-and-collect, and online delivery). The stores in SUPR's portfolio are dominant in their respective catchments. The top four supermarkets report an increase in their grocery delivery capacity by over 100% (adding 2 million slots) versus pre-pandemic. Additional infrastructure, including delivery van facilities, click-and-collect areas, and systems, has been put in place. Operators are using their existing stores, rather than creating new bespoke centralised fulfilment centres, and thus optimise complementary omnichannel systems.

Sainsbury's JV Stake Increase: SUPR increased its stake in Sainsbury Reversionary JV- which owns a portfolio of 26 Sainsbury's assets valued at GBP1.06 billion at FYE22 - to 50% in January 2023 from 25.5% by buying out one of the JV partners. Sainsbury's has since utilised its FY23 buy-out option to buy 21 of the 26 JV assets. Resultant monetisation cash flows are expected in March and June 2023, which SUPR will use to pay down debt, including the debt it incurred for increasing its JV participation. SUPR's JV investment was focused on returns from the valuation uplift which, from SUPR's perspective, was achieved with a 1.9x money multiple and 26% internal rate of return on its cash investments. Four of the five remaining JV assets will be on 15-year leases to Sainsbury's while one will be sold on vacant possession.

Acquisition-Led Growth: Fitch expects SUPR to continue to grow by acquiring omnichannel supermarket assets into its direct portfolio. SUPR acquired GBP570 million in FY21, GBP388 million in FY22 and approximately GBP300 million in 1HFY23. The acquisitions are in the 4%-5% net initial yield (NIY) range. The UK supermarket property market has an estimated GBP100 billion market size, presenting opportunities for SUPR to scale up, but 60% of this relies on tenant retailers unlocking their owned or self-created sale-and-leaseback structures. SUPR has no development exposure.

Moderate Financial Profile: SUPR has a long-term policy LTV range of 30%-40%, translating into net debt/EBITDA of 8.0x-9.0x. Additional debt drawn down for the increased participation in Sainsbury Reversionary JV are partly repaid in 2HFY23, and final monetisation proceeds are received only in 1QFY24. However, with little rental revenue to show for the FY23 investment, net debt/EBITDA would be slightly higher in FY23. Nevertheless, Fitch's forecast for FY23 leverage at around 8.2x is well within the rating sensitivities.

Financial Profile Headroom: Management plans to access additional equity to maintain its target LTV as the portfolio grows (FYE22 Fitch-calculated LTV: 19%). Debt drawdown for further acquisitions and increasing JV participation in 2HFY23 has resulted in LTV of around 40%. SUPR expects to reduce this to around 30% in July 2023 when it pays down debt with JV monetisation proceeds. Interest coverage was above 5.5x in FY22, which provides adequate headroom to absorb the higher cost of debt when it refinances GBP240 million of outstanding secured debt in FY23 and FY24.

Derivation Summary

The Fitch-rated retail real estate portfolio includes entities with (i) full-service large retail shopping centres (SCs); and (ii) affordable-rent, convenience-led, local SCs and retail parks. The full-service large SCs include Hammerson plc (BBB/Stable), primarily in the UK, and pan-European Unibail-Rodamco-Westfield SE (BBB+/Negative). The second category includes Lar Espana Real Estate SOCIMI, S.A. (BBB/Stable) in Spain, IGD SIIQ S.p.A. (BBB-/Stable) in Italy and NewRiver REIT plc (BBB/Stable) in the UK. SUPR's portfolio fits more into the second category, with its omnichannel strategy mitigating risks from rising e-commerce within retail.

The SUPR portfolio is carefully assessed and chosen by SUPR and its investment advisor Atrato Capital Limited based on each supermarket unit's catchment dominance and sales volume as well as the operator optimising these stores through its omnichannel strategy. This is comparable to pan-European Via Outlets B.V (BBB+/Stable), which actively manages its outlet centers and exploits technology to analyse tenant sales (incentivised by turnover-based rent upside).

Within the Fitch-rated retail real estate portfolio, SUPR is unique in its sector specialisation, which leads to tenant concentration. SUPR's tenant profile reflects the UK grocery market that is dominated by few large operators. Grocery is an essential service with growth prospects in the UK, which along with the regional dominance of SUPR's supermarket assets and omnichannel strategy, supports the long-term prospects of these stores within UK retail.

SUPR's long-term leases (portfolio WAULT of 15 years) and affordable rents (rent/turnover of 4%) is comparable to NewRiver with its 6% rent/store turnover and results in resilient rental income in contrast to unaffordable rent pressures for peers like Hammerson (above 20% occupancy cost ratio (OCR)) and Unibail (2019 OCR of 15.5%). While 83% of the leases have RPI/CPI/fixed-rental uplifts, these are capped at 4%-5%, which has kept rental uplifts generally below food inflation and rents affordable.

Among rated retailers, Lar Espana and IGD with their portfolio quality, resilient rental revenue streams and NIY of around 6% have net debt/EBITDA rating sensitivities of around 8.0x for 'BBB+' and 9.0x for 'BBB', respectively. SUPR's portfolio quality along with its defensive income stream owing to the essential nature of grocery business compares well with Lar Espana's and IGD's and hence has net debt/EBITDA rating sensitivity in the 8.0x-9.0x range. In comparison, the non-prime portfolio of NewRiver has a net debt/EBITDA rating sensitivity of 6x for an upgrade to 'BBB+'.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Fitch has simplified forecasting by using annualised rents such that all assets acquired part-way during the year make a full-year contribution to rents

Eighty-three per cent of rents have upward-only RPI/CPI/fixed uplifts but which are capped at 4%-5%. The rest are subject to open-market reviews. Fitch's rating case uses a blended 4% for FY23 and FY24, 3% for FY25 and 2% per year in FY26

Acquisitions of GBP360 million in FY23 (mostly already taken place in 1HFY23), GBP130 million in FY24 at 5%-5.5% yield, financed mainly by drawing down on existing debt facilities. The rating case assumes no further acquisitions after FY24. For acquisitions beyond FY24, Fitch would expect SUPR to raise additional equity to keep LTV within its 30%-40% range

Cash proceeds from the Sainsbury's Reversionary Portfolio JV of around GBP380 million are used to pay down debt. No related special dividend required as a REIT

Ordinary dividends at GBP0.06/share as per SUPR's business plan. Average of cost of debt reflects the effect of interest-rate swaps entered in FY23

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Increased tenant diversity while maintaining a focus on top quartile omnichannel supermarkets

Net debt/EBITDA below 8x

Net interest cover above 4x

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Net debt/EBITDA above 9x

Net interest cover below 3x

Funds from operations dividend cover below 1.0x

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Good Liquidity: SUPR plans to partly pay off before FYE23 the additional debt drawn down during the course of 1HFY23 for acquisitions and increased participation in the Sainsbury Reversionary JV using proceeds from the JV monetisations. Future cash generation is adequate to meet debt repayments. SUPR has entered into early negotiations to refinance debt maturing in FY25. In addition, SUPR maintains RCF facilities with various banks, of which GBP170 million remained undrawn as at end-1HFY23.

At this time of valuation uncertainties (including the potential for independent valuation to overstate the decline), the likelihood of an LTV breach by SUPR is not regarded by Fitch as a significant rating risk as an LTV breach in a secured financing has remedy options including equity cures, additional unencumbered stores, and capacity to bring forward plans to refinance the debt.

Secured and Unsecured Debt Mix: Until FYE21, SUPR had only secured bank debt. In FY22, it started to transition to unsecured debt sourced from banks. SUPR continues to consider issuance of unsecured bonds or private placements once market conditions are more conducive.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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