After a period in which the UK supermarket property investment market reflected the problems of the sector’s major operators, it has now recovered some ground and is proving increasingly popular with investors, according to the latest Colliers and MSCI UK Supermarket Investment Report.

The report says that despite the events of last year which muted property investment activity generally, around £1.1bn of supermarket assets were traded in 2016 - a very similar level year-on-year.

Colliers’ head of retail capital markets, James Watson, commented: “In an uncertain world, long-dated income from relatively sound covenants once again looks increasingly attractive to investors. The main structural concern about the current market is supply. Without substantial development programmes and an absence of sale & leasebacks, it will become increasingly difficult to source the best supermarket assets.”

Sale & leasebacks by the Big Four operators (Tesco, Sainsbury’s, Morrisons and Asda) used to be a major source of asset supply to the market. However, 2016 saw no sale & leaseback activity for the first time since the early-2000s. With operators generally fighting to bring costs under control, it did not make sense to further expose themselves to factors such as inflation over which they have no control.

In contrast, Tesco has become a net buyer of stores as it continues to exercise ‘buy back’ options to mitigate its exposure to property cost. It is estimated that Tesco has spent around £450m on store acquisitions in the past 18 months.

Watson comments: “Taking full control of these assets leaves Tesco free to ‘reboot’ the stores as they wish and align them with their ongoing strategy.”

The £54bn ‘air rights’ market
However, there is another reason that Tesco is continuing to buy back its stores…it wants to be able to sell its ‘air rights’ above its supermarkets and car-parks to property developers so they can build flats on them.

Air space is rapidly becoming a tradeable commodity in the London property market, with a number of companies moving to capitalise on what could be an extremely lucrative market. Developments in London could deliver 180,000 new homes worth £54bn, according to a report by urban planning firm HTS Design.

New York has been trading and transferring air rights for decades with shorter buildings able to sell the air space above them to property developers. However, to combat over-development in historic areas of interest, the department of city planning in New York is now considering proposing a new tax on all air rights deals that take place in certain districts, including the famous theatre district, but such a move is unlikely in the near future here in London.

Tesco has already latched on to the potential of its air rights. In November last year the firms finance director Alan Stewart identified 15 large sites in and around London as suitable for redevelopment, projecting the release of £400m of value from their property portfolio.

The company has already dipped their toe into the water, completing a huge 250 apartment development on top of their Streatham Common store in south London. Two bedroom flats in the complex now sell for around £500,000.

Tesco’s discussions are a stark contrast from its indulgence in sale and leasebacks under former boss Philip Clarke who agreed £2.7bn worth of deals in an attempt to slash debt. But Stewart has ruled out a return to sale and leasebacks, saying Tesco was looking at buying back freeholds, which would help reduce its rent liabilities. He added that Tesco plans to spend around £23m in the next two years buying back property and the retailer is also in discussions about selling space to other retailers and restaurants, including McDonald’s, which will help drive footfall to its stores.

Growth of discount supermarkets is slowing
The discount supermarket operators, led by Aldi and Lidl, have been major disruptors in the sector but there is now some evidence that their extraordinary growth curve is slowing. Watson comments: “In 2014, new Aldi store openings only contributed around 27% to total sales growth, but this figure had risen 83% in 2016. However, if the contribution of new stores is stripped out, year-on-year sales growth for the chains existing stores in 2015-2016 falls to less than 2%.

“This slowdown in growth, combined with greater challenges in securing new sites means market share gains for the discounters may begin to plateau. We don’t expect combined discounter market share to exceed 14% in five years’ time.”

The supermarket sector’s property investment market continues to have a definite two-tier structure in terms of yield profile. The average yield for prime assets has remained relatively unmoved at around 4.5% for conventional inflation-linked rent review, long leased supermarkets, while secondary asset yields are around 5.75-6.25%.

Colliers expect 2017 to be a more positive year for the supermarket sector, concluding that yields may fall over the next 12 months although the prevailing yield gap between prime and secondary assets will remain at around 125 basis points the firm said.