End of the supermarket in supermarkets

In recent years, real estate types have often parroted the same answer when asked to name the safest slice of the commercial property market for risk-averse investors: supermarkets.

People will always need to eat, rendering the sector as defensive as can be, they said, adding that the oligopolistic supermarket behemoths are as solid as the proverbial rock.

This hunger for hangar-like units begat a wave of sale and leaseback deals that, in the UK alone, has seen supermarket chains offload 268 stores, with a combined value of £6.8bn, as of December, according to MSCI, the data provider.

In 2014 alone, blue-chip investors from BlackRock, Aberdeen and Deutsche to the BP Pension Fund, the Universities Superannuation Scheme and Canada Life, spent £1.3bn buying stores, according to Colliers International, a property company.

Yet, of late, some cracks have begun to appear in this carefully constructed edifice.

Last month Tesco, the UK's largest retailer, stung investors by writing down the value of its property estate by £4.7bn. Its property, plants and equipment is now on its balance sheet at £20.4bn, 16.5 per cent less than a year ago.

In February, rival Wm Morrison took a £1.3bn property writedown, while the value of its tangible assets was marked down 19.1 per cent to £2.9bn.

The duo kick-started what might ultimately come to be seen as a lengthy period of retrenchment by the supermarket sector, with Morrison announcing 23 store closures and Tesco 43.

So if the supermarket chains are marking down the value of their property estates by 15-20 per cent, should institutional investors have to do the same?

One might think third party-owned property assets might be more vulnerable still; at the margin a retailer would surely prefer to shutter a store it no longer owns than one it still has on its books, particularly if the former has a short lease.

Colliers reports that some institutional investors are now "discreetly" looking to exit from the poorer stores in their portfolios, but are trying to sell at "yesterday's valuation", which the market is, perhaps unsurprisingly, "resisting".

"This is a significant change in the retail market. It is something that we as fund managers are monitoring closely," says Chris Urwin, global head of real estate research at Aviva Investors, which owns some supermarkets. "Go back a few years and people were thinking of [a store] almost as an income stream and not paying any attention to the fundamentals."

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For many years investors were rewarded. Even as high streets in many parts of the UK, Europe and US hollowed out as smaller retailers struggled, supermarkets continued to show their resilience by eating up market share.

UK supermarkets delivered an average return of 11.7 per cent between 2009 and 2013, comfortably beating the returns from non-supermarket retail every year, according to data from MSCI.

"Supermarkets have proved to be a real estate asset that has held up well since the global financial crisis as an attractive, bond-like, secure investment," says Angela Goodings, associate director of research at TH Real Estate, part of TIAA-CREF, the US financial services provider, which has $82bn of property assets, about $30bn of which is in the retail sector.

<>"[Inflation-linked] 20-year leases were very attractive to investors who were risk averse and it has proved to be a very secure sector."

However, in the UK at least, large supermarkets are now being assailed by a triumvirate of terrors: online food sales have risen sharply; so-called "hard discounters" such as German duo Aldi and Lidl have seized market share; and more people are now opting for regular "convenience" shopping rather than a weekly binge at big-box outlets.

"Supermarkets have yet to demonstrate how they are going to find a way to become competitive. It is quite possible that the amount of supermarket space that exists in a few years' time is less than it is today, certainly the space occupied by the established supermarkets," says Mr Urwin.

The implications are starting to percolate through to investors.

"There are structural issues where [supermarkets'] race for space has led to an oversupply in certain areas," says Ms Goodings. She adds that while non-supermarket retail assets generated capital growth of 8 per cent in 2014, "last year we saw nothing for supermarkets. The other asset classes are in catch up."

Yet Ms Goodings says it would be wrong for the entire supermarket sector to be written down, arguing instead that the market is polarising and fragmenting.

Whereas the strongest-performing stores in the best areas might still be valued on a yield of around 4.25 per cent, secondary assets might have drifted out to a yield of 5.25 per cent. "For some of the weaker areas there certainly will be writedowns," she adds.

Mr Urwin agrees the sector is becoming less homogenous. "A year ago, supermarkets were probably trading at fairly similar levels. Now more concern and attention is being given to the characteristics of the store itself.

"The demand is still there for long-term leases that trade well and are in dominant locations," he says.

Investors are also thinking a little more about potential alternative uses of the sites they own, in case their leases are not renewed. In London and other parts of southeast England, residential development might be a lucrative option, Mr Urwin says.

Harry de Ferry Foster, fund director of Cordea Savills' £920m Charities Property fund, is more upbeat, arguing that Tesco "probably deliberately cut too hard" when writing down the value of its stores, in order "to get all of the bad news out of the way".

"I don't think anyone worries that they are not going to pay the rent, that they are going bust," he adds. "Tesco yields have drifted out, [but that is] primarily because of sentiment. There are very few [stores] trading [on the secondary market]."

. . .

So far, at least, worries over the declining value of supermarket stores appear to be largely a UK phenomenon.

As far as Europe is concerned, Chris Urwin, global head of real estate research at Aviva Investors, says the "big weekly shop is quite a British thing and in other parts of Europe people have had the discounters and been willing to use them for longer".

Angela Goodings, associate director of research at TH Real Estate, says the supermarket sector has been "less attractive" to property investors on the continent, although supermarket-anchored shopping centres have gained some traction.

These types of shopping centres are also coveted investment assets in the US, with close to 200 transactions in the past two years, says John Ragland, head of retail at TH Real Estate.

While margins are being squeezed for traditional supermarket operators and the sector has seen some consolidation, it is not being assailed by the forces at work in the UK, says Mr Ragland.

Internet-fuelled home delivery "has not really taken off", he says, while Europe's hard discounters remain absent and shopping patterns have not changed.

As a result, supermarket valuations are still rising, he says, with yields typically around 5.5 per cent to 6.5 per cent "for the good stuff".

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