Shares in Supermarket Income (SUPR ) have tumbled 6% today after broker Peel Hunt downgraded the popular real estate investment trust (Reit) from ‘hold’ to ‘reduce’, expressing concern at its high valuation.

Investors have piled into the stock this year, attracted by the steady income it earns from long, inflation-linked leases on a portfolio of well-positioned stores in a defensive sector. That’s pushed shares in the wealth manager favourite to a near 15% premium over net asset value this year.

With the Reit’s finance costs rising with interest rates, and questions over the sustainability of its rents, analyst James Carswell said that the high rating looked like an ‘outlier’ in the sector where Secure Income (SIR ) and LXI (LXI ) Reits trade close to par ahead of their merger, and the smaller Value and Indexed Property Income (VIP ) and Alternative Income (AIRE ) trusts stand on discounts of 9% and 12% below net asset value.

Carswell cut his price target for Supermarket Income from 125p to 115p, sending shares, which had risen 9% to 129.5p this year, 7.7p lower to 121.8p.

‘Whilst by no means alone, Supermarket Income Reit looks relatively exposed to recent interest rate increases, with just 44% of existing drawn debt hedged and additional debt required for new purchases. Our analysis suggests current rates could reduce our EPS [earnings per share] forecasts by 8%, and hedging now for five years would lead to a c.20% downgrade.’ That could potentially leave the 5% yielder’s dividend uncovered, Carswell warned investors.

Following a £307m share issue this year, Supermarket Income has £700m of firepower at its disposal to invest, including a credit facility and the proceeds of store sales to Sainsbury’s. However, Carswell cautioned that the Reit was investing in a seller’s market and that with high prices depressing rental yields, the company may have to sacrifice asset quality to support its dividends.

From its launch five years ago to late 2020, all the large stores bought by the Reit had leases linked to the retail prices index (RPI). However, since then it started to buy assets with fixed and open-market rent reviews, lessening its protection against inflation.

‘Recent purchases appear to be less RPI-focused and are increasingly including a significant non-food element, and we would expect this to continue,’ the analyst said, while noting that the fund managers at Atrato had made this shift due to their confidence that organic rental growth would be strong. Currently, 10% of the portfolio’s rent comes from non-food units.

Are rents too high?

Most worryingly, perhaps, Carswell cited comments by Sainsbury’s at a recent analyst meeting when it discussed its decision earlier this year to exercise an option to repurchase 21 of 26 stores in a portfolio jointly owned by the Reit and the BA pension fund. The decision to leave out five stores could have been part of a negotiating tactic by Sainsbury’s, but it also implied the chain thought the grocery sector was ‘over-rented’ and rents were too high as retailers battle with cost inflation and a tight squeeze on margins.

‘Now we looked at some of these stores and we thought: we don’t think the passing rent is necessarily the right rent and, for some of those stores, we don’t necessarily want a 20-year lease on them,’ Peel Hunt quoted Sainsbury’s as saying.

‘We would be hopeful that an agreement can be reached on some if not all of the stores, but given Sainsbury’s comments, we would not be surprised to see a material reduction in rent,’ said Carswell.

Noting the desire of Sainsbury’s to sacrifice ‘property profit’ to gain the right leases on its stores, the analyst concluded: ‘Perhaps this is not such a strong endorsement for physical supermarkets as we once hoped?’