If you want to know what the weather will be like tomorrow, just look out of the window. The thinking here is that, more often than not, tomorrow’s weather is pretty much a continuation of today’s weather. There are always risks in doing so, but it would be tempting to apply the same principles to the UK housebuilders.
Left to their own devices, the housebuilders would happily increase output, offsetting any increase in raw material and labour costs with higher selling prices. And without significant outside interference, this looks to be the likely scenario for the coming year. The key pillar of support is the continued and chronic imbalance between supply and demand. The UK needs to build around 250,000 homes a year just to meet demand. But on top of this we have to add years and years of undersupply, which means that achieving a government target of providing 1m new homes by 2020 (which seems unlikely) will not solve the shortage.
This target was preceded by plans in 2008 to build 200,000 houses a year by 2016; the actual figure will be nearer 170,000. And rather belatedly, housing minister Gavin Barwell has admitted that the 1m target will be missed, and the provision of £18m to help local authorities improve the planning process that housebuilders constantly cite as one of the principle constraints on greater output looks miserly at best.
Ironically, the housing shortage has not been created as a result of housebuilders holding back on construction; it has evolved as a result of a collapse in local authority building, better known as council houses. Social housing is a lower-margin business as far as the major housebuilders are concerned, but this is largely academic because the funding required to sponsor a major social housebuilding programme simply isn’t there. An effort was made to address this in the Autumn Statement, with a £2.3bn infrastructure fund to help build 100,000 new homes and a further £1.4bn to sponsor 40,000 affordable homes. But these initiatives are just the latest in a long list of announcements that so far have led to very few extra spades in the ground.
For the big housebuilders, that supply/demand imbalance will be the mainstay of support for future growth. We’ve looked at the supply side, but what would happen if there were a change on the demand side? Perhaps the biggest governing factor here is economic growth. If there is a reasonable amount of wealth creation then demand will hold up, but only if a host of other factors remain favourable. Mortgage availability remains an important factor, and despite tighter lending criteria designed to choke off attempts to secure mortgages that stretch the borrower’s finances, at least the major mortgage lenders are lending.
Mortgages are also cheaper than they have ever been, and sensible borrowers lock themselves into a fixed-rate mortgage for as long a period as possible. For its part, the government seems keen to help people on to the first rung of the housing ladder by using a string of financial initiatives, the most prominent of which is Help to Buy, a crucial measure that in some cases accounts for a third of annual sales by some housebuilders. And any thoughts about the referendum vote putting a block on accelerated construction were firmly laid to rest after data released for October showed that contracts for residential construction rose to £2.3bn, the highest level ever recorded.
After struggling in the wake of the financial crash, housebuilders have recovered strongly in the past few years, leading to suggestions that they may now be overvalued. This is a much debated subject. Applying the usual valuation criteria and adopting a cautious stance might have led some investors to cash in their profits a year or two ago. It’s not a profit until you take it, but anyone doing so would have missed out on a further sustained run that brought the valuation argument into the spotlight. Shares in all the major housebuilders trade in excess of net tangible assets per share; some, such as Persimmon (PSN) and Berkeley Group (BKG) are at more than double net assets. However, it’s worth pointing out that these numbers pay scant regard to the development value of the land banks held (these are on the books at cost). It’s also worth taking a look at operating margins. In many cases these are still below the levels achieved before the financial crash. However, for these to grow further depends on a number of factors remaining favourable.
Safe as houses?
At the moment, land prices remain pretty benign, and housebuilders have been using their capital to greater effect by increasing the number of land creditors that they use. At the same time, they employ and adhere to strict hurdles on the return on capital employed. Part of the reason that land prices haven’t shot up is the fact that there are fewer potential buyers. Many small and medium-sized housebuilders went to the wall after the financial crash, never to return. Construction costs will also play a part. These are expected to increase by 3-5 per cent, but the increase will be more than covered by an increase in selling prices, which would only have to rise by 1.5-2.5 per cent. However, there is a broad trend showing a significant slowdown in house price inflation. The trend line is anything but steady, though. Negligible growth in September was followed in October by the strongest month-on-month rise of the year.
Sterling’s weakness is unlikely to prove a burden as very few raw materials are imported, while the skills shortage that has led to wage inflation is slowly being addressed as a result of an increase in apprenticeship schemes. Arguably, progress here could be hit by any move to restrict the number of skilled workers entering the UK, although it’s worth pointing out that half of net immigration comes from countries outside the EU. It’s hardly a case of overseas workers stealing jobs for people living in the UK; there is a shortage of skilled labour already.
If we go back to our supposition that 2017 will be more of the same for housebuilders, what could knock this off course? The UK’s exit from the EU will be a key influence on investor sentiment, although by itself there is little risk of unsettling the housebuilding sector. This will only come from a deterioration in the economic picture, whereby people’s ability or inclination to buy a new house is diminished. There is also the risk that sterling weakness will drive inflation higher and increase pressure on the Bank of England to increase interest rates. This seems highly unlikely, though, given that higher inflation will be cost-led rather than demand-inspired. The other danger (again unlikely) is that the government could withdraw incentives such as buy-to-let, which would in turn make it much harder for first-time buyers.
We view these as possibilities far more than probabilities. Sensibly, most housebuilders have adopted a more cautious stance, given the level of political uncertainty. Some have opted to top up their land banks rather than increase them, while there has also been a marked rise in the use of strategic land, bringing this into use by gaining planning consent. Housebuilders are also much better placed financially. Instead of being heavily geared, many now run a net cash position and have earmarked significant dividend payments for the next four years.
Ultimately, housebuilders remain cyclical performers, and assuming the UK economy remains in decent shape, the year ahead will, despite all the media hype over Europe, probably bring more of the same.
Real estate: Time to be selective
Shares in most property companies were tarred with the same brush in the wake of the EU referendum, although the only new entry into the valuation equation was uncertainty. So, when the wheels didn’t fall off the real estate bandwagon, share prices started to recover, although many are still nursing significant discounts to net asset value. What this suggests is that most share prices significantly undervalue the company’s worth, or it means that values are too high. This is the ‘how long is a piece of string’ quandary, and looking forward to the year ahead suggests that the current mismatch will unfold, but which way?
Let’s clear the decks to begin with and consign to the dustbin all the hysteria in the popular media alluding to post-referendum Armageddon – much in the same way as we have to dismiss the fairy stories about London being flooded with US citizens running away from Donald Trump. Underneath all of this, life goes on.
Leaving London to one side for now, it’s clear that activity in the main regional centres in England is doing rather nicely. After years, if not decades, in the economic doldrums, there is a real sense of vitality emerging from areas such as Birmingham, Leeds and Manchester. So much so that inward investment is coming from the likes of Chinese investors, with Birmingham attracting more investor interest than anywhere else outside London. And for Manchester, the government has shown its desire to attract £5bn of foreign investment for 13 major development projects, with a specific emphasis on attracting Chinese investors.
At this point, we’ll take a look at the various constituents of the real estate market, which remains a highly diversified sector. After the financial crash, investment in new commercial space slowed to a trickle. Rents fell, which made new construction financially unviable. This remained the case after the economic recovery increased demand, and only now is the supply/demand imbalance starting to narrow. Rents are increasing, which is good news for the regional real estate companies, and the pace of these rent rises has been accelerated because landlords have been able to trim back incentives such as rent-free periods.
Much the same can be said for the specialists in retail distribution centres. Purpose-built space was conspicuous by its absence in the wake of the financial crash, and the whole market was caught off guard by the change in consumer habits, whereby internet sales rose rapidly. This increased the need for big-box distribution centres, especially for those located close to large conurbations such as London. However, the scope for rental growth came under the spotlight after the referendum, with rental growth flatlining in the past six months. The worry here is that, not only will new supply finally start to close the overall shortage of suitable big boxes, but a perceived stalling in earnings growth will encourage consumers to sit on their hands. This has yet to be established as much more than a projection that has little basis in reality because there are so many unknowns that could affect consumer spending habits one way or the other. It’s also worth pointing out that many big-box landlords have managed to secure tenants with long-term leases and upward-only rent reviews.
London is its own special market, and was hit hardest in the wake of the referendum amid concerns that the financial sector would shrink as international banks relocated to somewhere within the EU. However, that degree of nervousness is starting to dissipate to some extent. Investor and occupier demand are improving at a time when supply is more constrained, which should help to underpin capital values and rents.
Recent data from the Royal Institution of Chartered Surveyors (RICS) showed that net demand from occupiers recovered in the third quarter, while building starts and availability both declined. However, these trends still lack the pace seen before the referendum. The consensus view is that the baton for future growth will be handed to rental income rather than capital appreciation. Yield compression, in London at the very least, has run its course, and elsewhere the pace is expected to slow. This is because the uncertainty factor will continue to place constraints on the market.
However, central London has seen the sharpest pick-up in foreign investment enquiries, with overseas buyers looking to capitalise on sterling’s marked decline, a fall that is more than sufficient to offset the extra tax burden introduced earlier in 2016. Indeed, the percentage of RICS members who view commercial real estate in central London as overpriced fell from 79 per cent at the start of the year to 51 per cent in the third quarter. Nationally, around four-fifths of respondents continue to view commercial property at fair value or below fair value.
Buy-to-let
Private landlords are up there with the likes of estate agents, second-hand car salesmen and politicians; a lot of people don’t trust them. And to some extent this is justified, not least because in all three professions there are a few who spoil the reputation of the many.
The buy-to-let sector has been through a tough period as a result of tax increases and the proposed phasing out of mortgage interest relief on secondary homes. However, there are signs that landlords may not be as badly off as first thought. It’s important to remember that two-thirds of private landlords do not have a mortgage, and so are not affected by the withdrawal of interest rate relief. In fact, they are probably better placed because rents will rise as those with mortgages will push rents higher to recoup their drop in income.
According to the Council of Mortgage Lenders, mortgage advances in the third quarter fell by 4.4 per cent to 69,300, although this is still well up from April, when advances totalled just 50,000. Furthermore, while there were just 6,400 buy-to-let advances compared with the monthly average of 9,800 in 2015, the latest figures mark a significant recovery from the lows of around 4,000 in April and May. And renewed interest in the sector is coming from different sources. In the past two months, as a result of sterling’s sharp decline, Skipton International reported an 80 per cent increase in buy-to-let mortgage applications from British ex-patriots.
The jury remains out on how new tax laws will affect the number of private landlords. According to the Residential Landlords Association, around a quarter of 800 landlords surveyed are either selling or have sold properties. This may be so, but there are more than 5m private rented properties in the UK, so alarmist projections based on a tiny sample have to be taken with a pinch of salt.
New powers to regulate mortgages approved for small landlords have been granted to the Bank of England, and these amount to an affordability test on new buy-to-let mortgages. Such tests are already in place, but the new rules will require new mortgages to have an interest coverage ratio (rental income as a percentage of mortgage payments) of 125 per cent on the assumption that interest rates rise to at least 5.5 per cent. It’s hard not to consider that the concerted drive to generate revenue from private landlords is also an attempt to drive away the amateur player, whereas the professional landlord will ride out the proposed increase in taxes.
It’s hard to see how this will help to address the shortage of properties available for rent. And another blow was delivered in the Autumn Statement, with proposals to abolish fees charged by letting agents on tenants. Some may argue that these charges are in some cases excessive, which is probably true. But letting agents are not going to provide a service that they don’t get paid for. So, while they may have to foot the bill in the short term, over a longer period, as landlord agreements come up for renewal, it seems likely that landlords will be asked to foot the bill, and the logical conclusion is that these charges will be recouped through higher rents. With such short-sighted legislation, it comes as little surprise that, financially, there will be no winners.
However, there is a new player on the block in the guise of the build-to-rent operator. The idea has been born out of necessity as institutional fund managers scratch their heads to find a decent return with an acceptable amount of risk. Government bonds are still considered safe, but returns have slowly fallen to zero in some cases. Investing in property has become an acceptable alternative, but the mechanics have only recently started to make this possible. Fund managers are not known for their housebuilding skills, and so tying up with an existing builder or a specialist property manager makes a lot of sense.
The business model works well for all concerned. For the fund manager, buying property and generating rental income is a long-term investment with the scope for achieving a decent return as well as benefiting from any capital appreciation in the underlying asset. For the builder, buying land, putting it through the planning process and building are all forward funded by the investor. And when the project is completed, they can offer a management service; that’s ground rent collection, maintenance and rent collection, for an appropriate fee. There are even advantages for tenants who will have a recognisable landlord more readily held to account. The progress made so far is somewhat embryonic; less than 70,000 build-to-rent properties have been built or are in the pipeline, while there are around 5m homes in the private rented sector.
2017: what’s in store
Answers on a postcard. What we must realise is that those brave or foolish enough to make projections for the year ahead are basing their ideas on a scenario that is perfectly plausible but entirely hypothetical. Our view is that the extremes one way or the other can be roundly dismissed. There is growing evidence that the voice of reason may be starting to gather momentum.
This sort of news is bound to dominate the headlines and provide the populist media with plenty of ammunition to fuel largely irrelevant and pointless speculation. Property is and always will be an attractive investment. The only challenge for investors is to read the cycle and identify at which point the sector stands. Nominal interest rates, a weak sterling and strong overseas interest all point towards the real estate sector performing well in the year ahead.
UK plc will continue to function, and in a low interest-rate environment the attractions encapsulated in the real estate sector will continue to draw in those looking for a longer-term and relatively low-risk investment return. However, it is wise to be selective, as always leaning towards rental income visibility, low gearing and limited development exposure.
