Housebuilders have gone from strength to strength over the past year. True, there has been the odd scare about rising interest rates and a house-price bubble about to burst, but these concerns have been largely swept aside by the ongoing imbalance between supply and demand.
Estimates vary, but most experts assume that around 250,000 new homes need to be built in Britain each year to match growth in the number of households. Annual housing starts for the year to September 2014 totalled 139,500 - up 17 per cent year on year, but still way below the volumes needed. Because there has been a shortfall for many years, a vast backlog of deficits has built up. The most obvious solution - public housebuilding - remains well off the political agenda (see chart below).
If anything, trading conditions became even more favourable in 2014. Help to Buy was extended until 2020, while the prospect of a premature increase in mortgage rates seems as remote as ever. On top of this, Chancellor George Osborne delivered a new range of stamp duties, the effect of which was to lower the tax burden on purchase of all but the most expensive properties - those selling for just under £1m and upwards. These three pillars of support seem unlikely to crumble in the coming year.
Other potential headwinds have yet to materialise. There was concern that land prices would start to erode margins, ending the days of building houses on land acquired at knockdown post-crash prices. Yet land price inflation remains benign. That's because the big builders have the field pretty much to themselves when it comes to bidding for land; small builders still struggle to raise sufficient finance, due to the risk-averse stance adopted by the major lenders.
Costs have risen, notably for raw materials such as bricks and labour, particularly skilled bricklayers and electricians. However, build costs are still only about half the eventual sale price of a new house, and for now higher selling prices are easily covering cost inflation. Furthermore, the squeeze should be offset by the impact of operational gearing as output ramps up to meet demand. Sourcing skilled labour from outside the UK should also help.
Not all commentators are singing from the same hymn sheet, though. There is a credible bearish argument for the housing sector, based on slowing mortgage approvals, softening house-price inflation, downward revisions to UK growth, and uncertainty ahead of the general election. Bears consequently reckon the spring buying season will disappoint, prompting analysts to downgrade their forecasts and investors to derate the shares.
However, we believe any underperformance will be a temporary affair. Demand for new housing will not disappear, and a moderation in house price inflation would actually help by making the current cycle more sustainable. Tighter mortgage regulations will also help nip in the bud any return to the heady days of 110 per cent mortgages.
The underlying picture for the housing sector is very rosy. Forward order books are now running at record levels, while cancellation rates are at historic lows. Moreover, demand for housing at the more affordable end of the market remains higher than ever. Profitability here may not be as impressive, but growth is more sustainable and less exposed to cyclical trends - and margins overall this year will still reflect the benefits of using more cheap land as the number of legacy sites acquired when prices were much higher continues to decline. Housebuilders should also benefit from greater use of strategic land banks, where 'raw' land is brought through the planning process.
Shareholders don't just stand to benefit with rising share prices. One of the most eye-catching features of the sector is its unusual dividend profile. Persimmon (PSN) and Berkeley Group (BKG), to name the most extreme examples, have in place capital repayment schemes that will deliver bumper dividends for at least the next five years.
| Company name | Share price (p) | Market value (£m) | PE ratio | Dividend yield (%) | 1-year performance (%) | Last IC View |
| Barratt Developments | 440 | 4,368 | 14.1 | 2.3 | 12.9 | Buy, 369p 10 Sep 2014 |
| Bellway | 1,761 | 2,152 | 11.2 | 3.0 | 7.8 | Buy, 1,820p 12 Dec 2014 |
| Berkeley Group | 2,333 | 3,158 | 9.3 | 7.7 | -11.7 | Buy, 2,641p 5 Dec 2014 |
| Bovis Homes | 794 | 1,065 | 12.6 | 2.7 | -5.5 | Buy, 773p 16 Oct 2014 |
| Crest Nicholson | 350 | 880 | 10.7 | 3.0 | -7.5 | Buy, 334p 25 Sep 2014 |
| Galliford Try | 1,235 | 1,016 | 13.1 | 4.3 | 3.8 | Buy, 1,218p 16 Sep 2014 |
| Persimmon | 1,506 | 4,615 | 14.5 | 0.0 | 19.0 | Buy, 1,519p 9 Jan 2015 |
| Redrow | 270 | 997 | 9.4 | 1.1 | -17.5 | Buy, 284p 2 Sep 2014 |
| Taylor Wimpey | 131 | 4,246 | 15.7 | 0.5 | 10.9 | Buy, 115p 31 Jul 2014 |
Favourites
The two standout candidates on our preferred list are Persimmon and Berkeley Group, both of which offer dividend yields of over 6 per cent. Yet all the major housebuilders look set to progress further this year. Forward order books for some housebuilders, including Persimmon, Taylor Wimpey (TW.) and Barratt Developments (BDEV) even ensure that projected output for the current year is already in the bag.
Outsiders
It's tough to pick an outsider in a sector in the middle of a strong upward cycle. On dividend alone, however, Barratt Developments offers the most miserly return, although we still expect the group's underlying performance to be strong.
