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How investors could profit by avoiding the post-referendum property panic
July 22, 2016

Let’s make one thing clear. If the UK economy dips into recession; interest rates rise as inflation kicks in; mortgage availability tightens and demand for new houses shrinks, then the housebuilders will enter a downward cycle. Meanwhile, a consumer slump and exodus of firms to Europe could, it is feared, put a dent in the commercial property industry. But will this happen? We don’t think so. In fact, rising above the hysteria of the popular press, we make enough room to consider the key component in the latest upheaval – economic growth.

Safe as houses

Taking the bear factors first; interest rates are more likely to fall than rise as the Bank of England does its best to reassure markets and to avoid a slump in economic output. Mortgage availability is unlikely to tighten. The government has bent over backwards to make it easier for first-time buyers to step on to the first rung of the housing ladder. And with Help to Buy assuming a greater air of permanence, mortgages are expected to be readily available. The Bank of England recently cut the countercyclical capital buffers commercial banks must hold, which could free up as much as £150bn for banks to lend out. The bear point here is that if house prices look set for a sustained downward correction, banks may be inclined to review their loan to value ratios, but not yet because house prices haven’t collapsed.

What’s more, with last year’s slump in oil prices being reversed and sterling losing ground, inflation will rise. However, this is not demand-led inflation caused by supply failing to meet demand and, just as in the immediate years following the financial crash, inflation is likely to be consistently above interest rate levels. There is also a worry that falling immigration could reduce demand for new homes, but this is not likely to be sufficient to eliminate the supply/demand imbalance.

The big unknown is how much lasting effect the referendum will have on economic output. Opinions vary, with some suggesting outright recession, which is two consecutive quarters of negative growth, while others have merely trimmed their forecasts – including, notably, the IMF; despite its dire Brexit prognosis pre-referendum of “severe damage”, it still expects UK GDP growth of 1.3 per cent in 2017. The point here is that the initial consequences of the vote are more political in terms of shock, unlike the last downturn when malaise in the banking sector tripped up the entire economy. However, if there is a sustained downturn in economic output this will hit where it hurts most for housebuilders; that’s employment uncertainty and a subsequent slide in transactional volume. Early evidence from research group GfK revealed that consumer confidence has shown the biggest drop for 21 years as a result of the vote to leave the EU. However, not too much should be read into these preliminary numbers as they are likely to be more reflective of the imbalance between negative media headlines and positive.

 

 

 

So where does all this leave the housebuilders? For some time now traditional valuations have been viewed as stretched, although this didn’t seem to matter that much as long as costs remained relatively benign and house prices shifted higher. The twin pillars of support in the wake of the recession were cheap land and house price inflation. While land prices are unlikely to accelerate, there has to be some doubt about house price inflation. Initial evidence suggests that prices may have fallen in the immediate aftermath of the referendum result and, together with the threat of increased labour shortages pushing up costs, margins could start to come under pressure. However, the cash position could hold up well because with significant land holdings, spending on new land could be reined in.

The next question is how well placed are housebuilders this time around compared with the financial crash. At that time, builders were highly geared, and had been chasing land at ever-increasing prices. This was sustainable as long as demand held up, which of course it didn’t. Sites remained unsold, land values collapsed, buyers vanished in a puff of smoke as mortgage availability dried up, and builders found themselves with dwindling income, crashing margins and unable to service their debts.

In the current situation, most builders are not highly geared. Indeed, so cash rich are the likes of Persimmon (PSN), Berkeley Group (BKG), Barratt Developments (BDEV) and Taylor Wimpey (TW.) that they are rewarding shareholders with very attractive dividends. On the land front, prices remain relatively benign. Many small builders have trouble raising finance on speculative developments, while others have disappeared altogether. That leaves only the larger builders and, sensibly, they have elected to apply strict hurdle rates when buying new land. So, bidding up and stoking land price inflation has not happened this time around.

The next unknown is demand. Transactional volume for existing houses has declined, with buyers and sellers taking a pause for breath; understandable in the wake of so much misleading information in the run-up to the referendum. But in the absence of an economic slump, demand is unlikely to diminish. Curiously, even if there were a slump, pent-up demand would simply start to grow instead. No referendum can stop people growing up and eventually wanting somewhere to live, apart from with mum and dad.

Establishing exactly what represents good value is harder to define. Back in August 2015 we asked the question, is it time to be more selective? At that time, Persimmon was trading on 3.3 times net assets compared with a sector average of nearer two times, and while the dividend payout was attractive, we questioned whether that valuation was looking stretched. Many people tended to disagree at the time, while others cautioned that rising land prices and labour costs would trim margins. Neither of these last two factors has been borne out, but the referendum has blown a hole in all of these valuation arguments, not because it influences them but because it has well and truly spooked the market. In fact, between last August and 23 June, Persimmon’s share price was virtually unchanged, but asset growth brought the ratio down to 2.6 times; post referendum it’s now trading on 1.7 times.

But is that still expensive given that Bellway trades on just 1.2 times, while Bovis trades at a discount to net assets? As our earlier article suggests, it could be time to be selective. Bellway, for example, has an exposure to the inner London market, while Bovis has always delivered a sub-par return on capital employed. Persimmon, however, has virtually no exposure in London. That’s being selective, but the referendum has tarred the sector with the same brush, suggesting that some stocks have suffered a justified correction in valuation terms while others look to have been harshly treated.

Following the sharp fall in prices, Aurora Investment Trust, now managed by Phoenix Asset Management, increased its stake in Barratt Developments from 11.2 per cent to 12 per cent and in Bellway from 7.1 per cent to 10.5 per cent. The fund is taking the long-term view, and the attraction of these two builders is that they concentrate on return on capital, an essential element of future profitability.

The housebuilders’ view

So what do the housebuilders have to say? In the immediate aftermath of the vote, several builders have issued trading statements, which cast an interesting light on how the short- to medium-term outlook is perceived.

Redrow (RDW) issued a combative update on the day the referendum result was confirmed, stressing that in the run-up to the vote there had been no impact on sales or visitor enquiries, with the forward private order book up by a half at the end of June from the previous year. Full-year results are expected to be at the top end of market expectations. At retirement homes specialist McCarthy & Stone (MCS), a rapidly ageing population (something else the referendum won’t stop) saw forward sales up by 23 per cent, and it now has all the reservations it needs to deliver full-year completions in line with market expectations.

Shares in Persimmon took one of the biggest hits, which is surprising given that its exposure to sites within the M25 ring is minimal. Finance director Mike Killoran suggested that all the short-term noise would hopefully dissipate at some point, allowing housebuilders to get on with the job in hand. He added that any correction in selling prices simply added to the sustainability of the business cycle. “No one likes double-digit price inflation,” he added. And to support the 900p a share dividend payout to be returned to shareholders by 2021, falling demand and a subsequent contraction in profits could be countered by fewer land purchases. Persimmon has a land bank worth six-and-a-half years’ output at current rates. Calling a halt for 18 months or so could generate in excess of £1bn of free funds.

Taylor Wimpey provides another example. Its share price fell 40 per cent in the immediate aftermath of the referendum, and subsequently recovered to be down 24 per cent. As a result, they now offer a forecast 2017 dividend yield of 9.5 per cent, which, if paid out, would cost £450m in cash. Set this against forecast post-tax profit of £630m, £200m in cash and around a £600m spend each year on land replenishment, and the dividend looks fairly secure. True, profits could fall, but the land spend could also fall. The company currently has 76,000 plots in the land bank, equivalent to five-and-a-half years at current output. On top of this, there is a strategic land bank (that’s without planning consent) of 107,000 plots, the largest in the whole sector. Assuming some draw-through from this – 8,660 plots last year – set against 13,200 completions last year, land purchases could be reduced markedly without seriously eroding the consented land bank, and consequently freeing up more cash. According to analysts at Peel Hunt, this suggests that, barring an economic meltdown, the dividend is well covered by strong cash flow.

The caveat here is that sentiment in the second half of this year could see a spike in the number of reservations being cancelled. However, sentiment is a fickle beast, and once the dust has settled, and it becomes clear that mortgage rates will remain at record lows and employment levels are holding up, any dipping could just be a passing phase. Only time will tell, but we are not as gloomy as some.

So how are the housebuilders placed to cope with falling demand? If demand falls, then prices will come under downward pressure, although build costs will stabilise because lower output will reduce the need to recruit skilled labour. House price inflation has been moderating for some time; that’s good news for the housebuilders because lower price gains make the cycle that much more sustainable. According to the Halifax, prices in the three months to June rose by 8.4 per cent from the same period a year earlier, but the rate is softening, with prices in the three months to June up just 1.2 per cent from the preceding three months. And it’s hard to see this trend changing, with some first-glance estimates suggesting that prices have fallen in the aftermath of the referendum.

How much of this is a knee-jerk reaction remains to be seen. But it’s important to remember that falls in the wake of the financial crash prompted a near drying up in mortgage availability, whereas the exact opposite holds true now. And the competition is hotting up, with Barclays (BARC) now offering headline zero deposit mortgages. That’s not quite the case, though. The 5 per cent deposit is waived, but a helper (ie, mum and dad) must put up a 10 per cent deposit, returnable after three years and accumulating interest on the deposit of bank of England base rate plus 1.5 per cent. Furthermore, income multiples for people earning over £50,000 have been hiked from 4.4 to 5.5. And it’s hard to see the government failing to support one of its key initiatives, and that is to solve the housing shortage. The cocktail of imponderables is bewildering, but once again nearly everything comes down to maintaining economic growth.

 

Overseas buyers swoop

If we’re not certain about whether to buy a property, overseas buyers are under no similar illusions. In the first week in the aftermath of the referendum, London estate agent Douglas & Gordon saw instructions nearly treble compared with the previous week. Many of the deals came from applicants based in Nigeria, the US, UAE, Russia and China, buying in US dollars and targeting property in the £1m-£2m bracket. The attractions are compelling, given that a combination of prices in prime areas, along with a fall in the value of sterling, means that overseas buyers can now pick up assets around 25 per cent cheaper than they could two years ago. Chief executive James Evans said: “Politically, we may be in uncharted waters, but many of our clients who delayed listing their property until 24 June were simply waiting for a result, one way or the other.” And since the start of the year, it has received 24 per cent more enquiries from relocation agents, reflecting a year-on-year increase in the number of corporations looking to move employees into London.

 

Torpedoed along with the mainstream housebuilders but deserving a worthy mention is MJ Gleeson (GLE). Selling land to hungry housebuilders in the south of England, it also builds houses in predominantly rundown inner urban areas in the north. As chief executive Jolyon Harrison pointed out: “Any couple in full-time employment can afford to buy one of our houses”. And given that average selling prices are around £125,000, that’s pretty much on the mark. True, demand for new housing sites in the south-east may slow, but not at anything like the pace that the lower share price appears to discount. Indeed, the company expects full-year results for the year to June 2016 to be at the top end of market expectations, having boosted house sales by more than 20 per cent. And the directors have been buying in, too.

 

Summing up

At the moment, the shock is predominantly political. That there will be economic fallout to some degree is inescapable. What remains unclear right now is the extent of that fallout, and that will be crucial in determining potential housebuyers’ inclination and ability to buy a new house. For shareholders in housebuilders, some will be nursing losses, especially those who bought more recently. The choice is to crystallise those losses now, on the premise that there are further falls to come, or wait until the market recovers. The alternative is to buy at the lower level and reduce the in-price. Those who invested more than three years ago are still sitting on a profit. And for those who accept the risk of further declines, there is the prospect of a very high dividend payout. Things will have to deteriorate significantly before builders start to rein back on dividend payouts.

Remember; market uncertainty leading to extreme levels of volatility make popular press headlines, but they in no way contribute to making sound investment decisions based on the underlying picture and the long-term outlook. True, profits may moderate, and the return on capital employed – already at historic highs in many cases – will start to come back. But unless there is a significant sea change in the housebuilding sector as the result of a sustained economic slump, the outlook for the medium term is far better than the recent savage fall in share prices suggests. One aspect that is already clear is in the secondary housing market. Existing homeowners are already showing signs of sitting on their hands, especially when faced with a small army of potential buyers putting pressure on asking prices. This will lead to a fall in the number of houses available, which could act to underpin prices. Almost certainly, though, transactional volumes will shrink; and that’s bad news for estate agents where fewer transactions mean less commission.

Interested parties will have their own take on what happens in the next six months; some of these will inevitably be contradictory. The key point here is that suppositions are just that, and the key ingredient that underlines any sound investment decision is still lacking, and that’s hard facts.

Capital Economics analyst Hansen Lu summed it up neatly when he said: “In all, it won’t be until the end of the month that we start getting data on housing market activity, sentiment and prices for July. Yet even disastrous or benign data from the first month could be a false post-Brexit housing market: when will we know? On the one hand, many buyers could potentially jump ship early on, only for uncertainty to start to ease, and for the market to quickly return to normal when they return to complete their purchases. And if uncertainty lingers and worsens over the period of several months, the market could worsen at a pace that is not immediately obvious in the first month or two of data. As a result, we will probably need to wait until September or October, when several months of post-referendum data are available, before we can form a more definitive picture for how the market has reacted.”

  

Outside view

Risks to commercial real estate investment and occupier demand have inevitably increased following the referendum, but we acknowledge that share prices already discounted slowing returns into 2016 and the initial price correction was severe. However, the subsequent rebound has reduced our inclination to view the sector as universally oversold.

We acknowledge that significant headline net asset value discounts are, at face value, appealing and the likelihood of M&A is also now higher given sterling weakness. However, our central view remains unchanged that Brexit is a negative event for UK real estate, with increased risk to occupier and investment demand due to uncertainty. We expect this to continue to weigh on sector performance, as the referendum equity shockwave settles.

It is still too early to know the extent to which UK real estate values will correct as a result of investment market uncertainty and risk of weakness in occupational demand. Using initial GDP revisions and history as a guide, we model a -5 per cent correction in values, which drives NAV downgrades of -10 per cent. The last four commercial real estate corrections prompted an average 17 per cent fall in property values, with yields moving out by 150 basis points.

However, unlike the great financial crash in 2008, this potential slowdown currently feels more akin to 1995, 2001 and 2012, with a break in the uptrend of UK GDP growth. This view is supported by recent GDP estimate revisions, which now show a consensus for growth of 0.4 per cent in 2017, down from 2.1 per cent before the EU referendum. In the past three corrections (excluding 2008) the average capital value decline was 4 per cent, with 40 basis points of outward yield movement. Clearly, if GDP turns negative the correction could be materially worse.

A protracted or acrimonious EU separation would add downside risk to our forecast revisions, but Brexit needn’t be as painful as prior corrections: with bond yields under pressure, real estate continues to provide attractive relative return. Weaker sterling enhances the affordability of UK real estate to overseas investors and supports exports and tourism. Markedly lower financial leverage reduces the risk of dilutive equity issue and provides capacity to exploit any market price dislocation. David Brockton, analyst at Liberum

 

Part 2: Commercial property hotspots - the sub-sectors best positioned for Brexit

Part 3: Exodus? Take a look at Europe, but don’t ignore London