This article is sponsored by Savills Investment Management
The pandemic has elevated risks and challenges for our communities and presented distinct difficulties for real estate investors. The ‘stay at home’ guidance has accelerated the use of technology in how we work and shop, with clear effects on behaviors and challenges for real estate occupiers and investors. It has also contributed to uncertainties around real estate’s recovery post-pandemic. However, the covid-19 crisis has also arguably shone a light on some of the more fundamental and robust strategies that investors can pursue.
In this article, we focus on the European supermarket sector and its many resilient and appealing characteristics, as the physical assets that house our food come with indexation, diversification, long leases, strong covenants and much more.
While long leases are an evident strength, we believe there is much more to this sector given its many positive attributes. Similarly, our recent survey of investor appetite observed a distinct preference for food retail and concern for the mainstream retail shopping environments of the high street and shopping centers.
Long lease attraction
One of its most prominent advantages lies in the length of supermarket leases. Liability matching investors are seeking long and secure income streams from real estate as the returns from fixed income remain low. The relative value of real estate appears favorable, although we know risks around parts of the market remain elevated as occupiers seek more flexibility. Long and secure leases will be favored by investors not just for their liability matching characteristics, but also for their relative safety.
At the same time, we recognize that commercial real estate leases have been shortening over time, with fewer occupiers prepared to commit to long lets. This trajectory has been accelerated by the pandemic. However, this is not our observation in the supermarket sector, where tenants continue to seek to secure their stores for the long term and are offering a CPI (consumer prices index) indexation on rentals. The consequence of this is that over time, such long and secure supermarket leases will stand out for their increasing rarity, as the pool of capital seeking such investments rises.
Not only are the leases long and typically contracted with simple fixed and index-linked rental uplifts, but the supermarket groups were largely financially robust prior to the recent crisis. This implies that on average the rents paid by supermarkets are both affordable and sustainable, although we should reflect that the long-contracted leases preclude the investor from capturing potential market reversion – that is, market rental uplift.
The pandemic reminds us of the sophistication and quality of Europe’s supermarket retailers, and the quality of their supply networks. Readers will be familiar with the ability of such groups to maintain their business despite the most challenging of circumstances – they not only stayed open but have largely thrived.
Results from the major European retailers typically show resilience of trade and indeed some growth as “stay at home” also meant a diversion of expenditure from eating out to eating in, for example. While we could assume that the reversal of the pandemic could erode some of the growth, the confidence with which new shoppers have embraced food-oriented e-commerce suggests that this will not wholly reverse.
Sustainability and social responsibility are pivotal to the best supermarkets’ management approaches. This has been embraced through the pandemic, with firms often leading with a high ESG focus. Europe’s strongest groups are largely embracing reduced packaging and environmentally favorable operating models. Stores are often facilities for recycling efforts, while many supermarkets have experimented with micro-power generation like PV cells, for example.
Most interestingly, we have seen retailers recently take a strong social stance toward the repayment of financial support from the public purse – UK food retailers have near universally returned covid-19-related support packages.
Adapting to modern consumer habits
How consumers receive their goods – the mechanics of e-commerce fulfilment – is also an important part of the supermarket story. It has long been argued that home delivery has unprofitable economics for the retailers, but surging demand from consumers forces firms to retain home delivery to retain market share.
As volumes have risen, the economics have improved. Some firms see collections picked in-store, while others have fully automated fulfilment centers, and others are adopting elements of both. The in-store technology solutions can also mean that the larger format hypermarkets have a new dynamic, as excess retailing floorspace can be given over to in-store fulfilment technology. We believe it noteworthy how traditional stores rapidly increased their e-commerce capacity through in-store pickup. Their proximity to end consumers appears fundamental, with the flexibility of picking models advantageous.
Taking this observation further, we also recognize that many groups offer click and collect services with some offering ancillary products to the traditional food offering. This extends the appeal of the physical supermarket at a time when traditional town centers are facing an uncertain future. Indeed, as the sense of destination is enhanced, other services could be added to the supermarket offering such as post offices, parcel pick-up and drop offs, garden center goods, pharmacies, opticians, banking services, car valet and servicing, and more.
Long leases reflect the challenges supermarkets face in securing suitable sites, but we recognize variation across supermarket types and national differences. In many countries, the zoning controls (planning consents) limit the capacity for new stores and give some ability for specific stores to dominate their area and offer relative predictability of a store’s likely success. However, there are challenges. Often smaller format ‘discounters’, trading in perhaps 10,763 to 16,145 square feet, can utilize infill sites, and we observe the chains’ rapid proliferation across Europe. As ever, detailed analysis is key in understanding the local dynamics against what is a largely compelling backdrop – not all supermarkets are the same.
A further attribute of supermarkets could prove valuable in the medium to long term. If we consider the layout of a traditional supermarket, we will recognize a purpose-built store on a large flat site, with ancillary parking close to the consumers, in a typically urban or suburban setting. That urban profile is appealing in the longer term, as it implies potential for value enhancement of the sites – as we have discussed in our work on Europe’s cities, urbanization and the constraints on land supply suggest a high underlying site value with considerable long-term optionality. While this would be a higher risk strategy, the potential of intensifying the sites will additionally make the assets appealing and defensive for the income-oriented investor.
The ultimate design of supermarkets has not fundamentally altered since the late 1980s and these stores offer a great deal of flexibility. This in turn reduces the risk of obsolescence, a factor commonly overlooked in other parts of the real estate market. The highly fashionable ‘big box’ logistics market is rightly identified for its many appealing characteristics, and likewise we can see fundamental advantages for supermarkets. These include lower obsolescence risk, greater flexibility for the stores, greater flexibility and value in the underlying sites, and higher yields to the investor.
The comparison does not end there. As described earlier, we see supermarkets fulfilling a ‘last-mile’ function to their consumers – logistics in all but name.
With the consideration of the attributes and risks of the sector, we believe that the supermarket sector offers security through many attributes. With apologies for the Oliver Twist references from the 1968 Lionel Bart musical: “Please sir, can I have some more?” … “More? More?!” … “Yes, please!”