FTSE 350: Housebuilders in a sweet spot

The Funding for Lending facility, initially designed to expand lending to small- and medium-sized companies, further depressed mortgage rates and boosted loan volumes. A lot of potential first-time buyers are still struggling to step onto the bottom rung of the housing ladder, notably in London and the south east, but the government's Help to Buy scheme has helped. Some housebuilders are now taking a third of all reservations through this subsidised mortgage policy.

These conditions have put housebuilders in a sweet spot. Land prices are still relatively low, and operating margins have been rebuilt as older, more expensive land has been used up. There have also been a number of initiatives to loosen planning procedures, although this still remains the number one gripe for most housebuilders. Their progress last year was impressive, as the share price performance suggests. Shares in Barratt Developments (BDEV) rose around 70 per cent. Even the smallest beneficiary, Bovis Homes (BVS), saw its stock rise by 40 per cent.

The question now is whether this sort of performance can last. In a normal market the above-book valuations of all the housebuilders would suggest that share prices are high enough. But this is not a normal market. Demand is being sponsored by subsidised mortgages, while interest rates are being kept artificially low, both of which will ensure that demand will continue to outstrip supply by a country mile. And although new-build has picked up, it is still a long way from pre-recession levels and only a fraction of what is considered necessary to make up for the shortfall accumulated during the downturn - let alone the natural increase in demand as the population grows.

Conditions could be less favourable this year, however. Share prices took a knock in November after the Bank of England restricted Funding for Lending to business loans - although many argue that increased confidence among lenders had already made the scheme redundant. Other pressures might come from rising costs as sub-contractors attempt to rebuild margins battered in the downturn. Margins could also be squeezed by rising land prices and increases in material costs, although these factors are relatively minor, as some or all of the increases can be passed on to customers through higher selling prices.

Without doubt, the one factor that could stop housebuilders in their tracks would be a significant increase in interest rates. This will happen at some point, but currently the outlook suggests that rates will be kept artificially low until the economy shows unambiguous signs of sustainable and decent growth. The hope by then is that the current squeeze on disposable income will have relaxed sufficiently to offset the higher borrowing costs. But this is all some way ahead, and for 2014 it is hard to see circumstances changing sufficiently to restrict housebuilders from making further gains.

FAVOURITES

For pure return it is hard to look beyond Berkeley Group (BKG) and Persimmon (PSN) for the hefty dividend payments pledged over the next five years. This sets them apart, but decent earnings and dividend growth can be expected across the whole sector.

OUTSIDERS

Managing a company in a strong cyclical upturn is much easier than holding things together when the wheels fall off, so there are no real outsiders in the current climate. However, Barratt Developments has yet to fully capitalise on the improved trading conditions. The outlook for Barratt is strong, and the shares have performed extremely well, but with a relatively low return on equity and a paltry dividend, there are better returns on offer elsewhere.