Housebuilders continue to reap the rewards

Those advocating that the bull run has gone far enough would point to the fact that all the major housebuilders have risen so far that each now trades at a premium to book value (see table). There has also been speculation about the creation of a new housing price bubble that's making it even harder for first-time buyers to get a foothold on the housing ladder.

However, the plus points, we believe, are still compelling. Interest rates remain at historic lows, and the chances of an early or significant increase in rates at the moment appear remote. Secondly, there is a chronic shortage of housing, and targets for new home construction just to keep up with the annual increase in demand are around double current output levels. And first-time buyers, as well as existing home owners, are being given a significant leg-up by the government's Help to Buy scheme. On the point of house price inflation, we remain pretty relaxed. True, prices in London and the surrounding areas are rising strongly, but this is not typical. In fact, prices in Scotland and Wales are still falling, while price inflation in the rest of England is negligible.

Yet, with so much attention on the housing sector, housebuilders have come in for some ill-judged criticism over alleged hoarding of land to squeeze supply and drive prices higher. This criticism isn't well-founded - the main reason that builders are increasing their land banks is to try and get as much as possible through the still imperfect planning system. It also makes sense to buy land when it is relatively cheap. Land price inflation (again remembering that outside London it's a very different market) has yet to rear its ugly head, although the big builders will inevitably face some pricing pressure as sub-contractors start becoming more selective about the jobs they take on, principally with one eye on repairing margins that were so squeezed in the downturn.

One of the biggest challenges facing the sector is how to develop a path that will allow builders to bridge the gap between current output and projected required output. Completions in 2012 rose just 1 per cent from 2011 to 115,620, and in the 12 months to June 2013 this had fallen to 106,820 - not even half the 240,000 annual completions needed just to keep up with new demand, let alone catering for the many potential first-time buyers who have been in rented accommodation for the past five years. On top of this, there are around 1m potential households waiting to be formed, mainly from young people with little choice but to live with their parents. London alone needs a 10,000-a-year increase in completions, but there is currently no mechanism in existence to make this possible. What's more, building enough affordable homes in London is unlikely to be achieved because of international demand. It kept the capital's building projects ticking over in the downturn, but now international investors are buying everything they can, keeping land and property prices sky high. Telford Homes, for example, has firm orders on flats it won't be building for another five years.

One of the ways to bridge the gap in London would be to ease the path for additional investment, notably from overseas buyers. But at the moment the tax regime presents a significant barrier because the whole system is vulnerable to attacks from politicians eager to score political points without considering the implications. Increases in stamp duty and the threat of a mansion tax simply aren't helping. Currently, council tax is based on 1991 property valuations, and whereas the old domestic rates were based on rental values, council tax operates through a series of fixed bands. So, for now, owners of the most valuable properties in England pay significantly less in local domestic taxes than they did 25 years ago, simply because property valuations have not been revised. And more recently, successive governments have introduced stamp duty land tax, an annual tax on enveloped dwellings, and capital gains property disposal tax, not to mention the mansion tax waiting in the wings that could come if there's a change in government. The tax regime is, in effect, a mess and a deterrent to investors.

The effect of these problems is most keenly felt in London, but still apply elsewhere where property prices are high. In the rest of the country, the planning procedure is still the key factor restricting a significant increase in output. And planning is the bug bear that most housebuilders reserve their most scathing criticisms for. There is another problem, however. Building plenty of houses is fine, but they must be in the right place - that is to say, where there are jobs.

But other housebuilders are using a different approach, such as M J Gleeson (GLE). While its land development side is buying land in the south of the country it also builds houses in the north of England. The model is to ask a local council for its worst derelict site and offer to buy it. Most councils jump at the chance and sometimes even wave the Section 106 (affordable housing requirement) strings that are attached to any development of more than 15 units. Gleeson then builds typical three-bedroom semis and sells them to the council house tenants situated around the construction site, offering them financial incentives into the bargain. It's good business, too, because the houses can be sold for about £110,000, which isn't much, but building plots can cost as little as £10,000 each. And on that basis, it looks like housebuilders could find a new lease of life outside of the capital, too.

IC VIEW:

In a normal market, housebuilders would be looking expensive on valuation grounds. But this is not a normal market. Demand is greater than it has ever been, as is the gap between output and demand. And with interest rates at record lows, government incentives in place, and lenders finally using cheap cash raised though the Funding for Lending scheme to provide mortgages, the sweet spot that housebuilders currently find themselves in looks set to continue for some time yet.