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Housebuilding heroes

Life is becoming tougher for the UK’s listed housebuilders, which means for investors the best days of the sector could be behind them. But, says Jonas Crosland, some companies have what it takes to beat the squeeze – and help solve the UK’s housing crisis at the same time
July 20, 2018

Stagnation in the existing housing market has finally started to percolate through to the builders of new houses, with sales price inflation flatlining or reversing at a time when input cost inflation is rising. So, given the meteoric gains made in the wake of the financial crash, is it time to bank those profits and take a step back from the housebuilders?

As with most investment decisions, there is no clear answer to this, but we would certainly suggest that this is the time to be more selective. The problem here is that those builders that could continue to make gains in terms of growth could now be tarred with the same brush as the broader sector. 

Berkeley Group (BKG), for example, has already indicated that growth has peaked, and that profits for the year to April 2019 will be lower. But does this mean that shares in MJ Gleeson (GLE), operating in the north of the country and selling homes at an average £124,000, should receive the same treatment? Gleeson recently revealed that sales growth in the year to June was a record 20.8 per cent, and its shares have so far held firm while others have faltered.

 

 

Housebuilders’ margin squeeze

Yet plotting a course for the wider housebuilding sector from here, we are faced with a sea of unknowns, with several key factors all capable of either underpinning or derailing the market. In the good old days, the sector’s performance was largely a mirror of economic performance and was relatively simple to follow. The current climate is different, and there is no one item that can be blamed for the slowdown, although sentiment probably plays as large a part as anything. 

As the home owning population and aspiring first-time buyers are assaulted with a barrage of imponderable scenarios surrounding Brexit, it is hardly surprising that for many the preferred option is to sit on their hands and wait for the fog of uncertainty to clear. That’s fine as far as it goes, and housebuilders can still tip potential buyers off the shelf of uncertainty by offering a greater level of incentives, such as paying stamp duty or filling the new house with goodies. 

Ultimately, though, this starts to eat into margins, but that’s not really a worry as long as the bottom line can be maintained through higher sales growth. So, with margins flatlining or falling, housebuilders increase the number of sales outlets. This works well only if the buyers are still out there, and this is starting to attract some doubt. At the same time, there is no mountain of vacant unsold properties looking for someone to buy, and the underpinning support of demand exceeding supply remains.

It is something of a conundrum because, although new homes command a premium over the price of existing homes, the housebuilders have very little influence in setting price levels as these are largely influenced by prices in the existing homes market. And right now there is precious little price inflation. 

However, at least one myth has been put out to grass, and that is the assertion that housebuilders have been holding on to permitted land to drive prices higher. A closer look at the construction procedure will show why: surveyors instructed to value land designated for new housing have to assume that the supply of new homes is not going to be so large as to affect the supply/demand relationship in the local area and the value of local housing. 

Thus, any valuation only holds true if it is based on this assumption, and this is crucial because housebuilders viewing a piece of land for development work typically on a residential value calculation. This is based on what the builder sees as the gross development value, achieved when all the houses are built and sold. All costs are then deducted to give a residential value. This is the key calculation, and assumes that new construction will not affect the value of surrounding homes. So, the pace of building and selling, or the so-called absorption rate, has to be tailored to reflect this. 

Another crucial point that restricts output is that on a large site, the housebuilder’s first customers and mortgage lenders would be unimpressed if they saw homes of the same type being built at such a rate as to pull selling prices lower. These are the findings of an independent review by the government led by Sir Oliver Letwin MP. There are plenty of examples of this restrained delivery. At Ebbsfleet in Kent, there are plans to build on 1,035 acres of derelict land to provide up to 10,000 homes. The area will also generate up to 20,000 jobs. This is great news, but the build-out will take the next 20 years to ensure the market remains in equilibrium.

 

Housebuilders' valuations

CompanyFwd PEP/NAVReturn on equity EBIT marginROICEV/EBITDA
(TIDM)(NTM)(last FY NAV)(last FY) (last FY)(FY)(FY)
Barratt (LSE:BDEV)7.61.514.30%17.40%15.20%6.1
Berkeley (LSE:BKG)9.71.929.10%28.80%37.90%4.5
Bovis Homes (LSE:BVS)12.11.58.60%12.40%12.00%10.8
Bellway (LSE:BWY)6.91.720.70%22.30%20.70%6.6
Crest Nicholson (LSE:CRST)5.81.320.60%20.20%19.30%4.9
Countryside (LSE:CSP)9.52.417.10%15.40%16.90%9.2
McCarthy & Stone (LSE:MCS)9.40.810.00%14.30%11.50%6.3
Persimmon (LSE:PSN)9.32.624.60%27.80%31.10%6.8
Redrow (LSE:RDW)6.71.620.50%19.40%18.10%6.1
Taylor Wimpey (LSE:TW.)8.21.817.70%20.90%23.60%6.2
Telford Homes (Aim:TEF)7.11.316.20%15.30%11.70%8.2
Galliford Try (LSE:GFRD)5.82.48.50%3.90%7.10%8.5
MJ Gleeson (LSE:GLE)14.52.515.30%20.40%24.10%11.8

Source: S&P Capital IQ and Investors Chronicle

 

Stretched affordability

Buying a house at the right time now appears to be outweighing the need to find somewhere to live. Too much emphasis is being placed on buying property with a view to lining the pension pot. But it doesn’t really matter because over the period of a 25-year mortgage, there is no time in recent history that house prices have not shown an increase. Buying a house in the early 1990s would have taken you through a plunge into negative equity before selling up in early 2000 at twice the buying price. Meanwhile, you’ve been paying back the mortgage.

Various measures introduced to encourage first-time buyers into the market have centred on the Help-to-Buy scheme, but something is not right when transactions are wilting at a time when buying a new house is supported by an array of helpful incentives. It’s all very well pointing out that it will take 17 years to save up a deposit for a house in the London suburbs, but the picture elsewhere is certainly not as daunting. 

The only solid metric is affordability. But even here, there are significant regional variations. In London, the affordability ratio, as measured by dividing average house prices by average wages, comes out at around 10 times, whereas in the north of England the ratio is half that. Both are much higher than previous historical standards, and it’s worth pointing out that many young couples starting out may not be earning an average wage. 

Going back to 1990, the difference in the affordability ratio was much less; three times earnings in the north and four-and-a-half times in London. It’s plain that house price inflation has galloped away from growth in average earnings. Using ONS data, in the second quarter of 1992, the average house price was £70,000 and the average recorded income of mortgage borrowers was £24,000. By the third quarter of 2017, average prices had risen to £303,000 and the average recorded income of mortgage borrowers to £63,000. A collapse in mortgage rates has made it possible to repay a mortgage on higher multiples, but the wheels will start to come off when interest rates rise. And while a significant increase in rates in the near term seems highly unlikely, here we come back to the media hype that sells newspapers and scares away potential buyers. Nerves are fraying.

 

Surveying the builders

Faced with such a scenario, do the housebuilders offer value? Everyone appears to have their own theory on this, but given the level of imponderables it is hard to see anyone arriving easily at the right conclusion. However, several factors are clear. House price inflation is melting away at a time when cost input inflation is not. Much of the latter can be placed at the feet of the government because of muddled thinking on the import of skilled labour. This hurts some builders more than others, but imported inflation because of sterling’s post-referendum weakness and uncertainty over whether a shortage of skilled labour will push up costs even further means that input inflation is unlikely to decline.

For the housebuilders, there are many potential paths to follow through what looks to be a period of restrained growth. Estimates are projecting that there will be 250,000 extra households each year for the next 15 years against annual output of between 150,000 and 200,000. So where will the extra homes come from, and what form will they take? 

First things first; the major publicly quoted housebuilders are accountable to their shareholders, and not to some misguided philanthropical concept of filling the housing gap. Major housebuilders never have and never will build enough houses to meet the housing shortage.

There are other considerations too. There are labour constraints, but not broadly based. For example, in the UK 20 per cent of plasterers, 10 per cent of carpenters and 5 per cent of plumbers and electricians work to build new homes. So it would be possible to attract more of these into housebuilding given some financial incentive. The odd one out is bricklayers, more than three-quarters of whom work in the housebuilding sector. Estimates vary, but if output is to accelerate, this will require a further 15,000 bricklayers – that’s about a 25 per cent increase in the existing workforce. These could be sourced from outside the UK, but this may prove tricky. Indeed, around half the workforce in London and a fifth in the south-east come from outside the UK, proportions that could be affected by the terms of the UK’s eventual exit from the EU. 

The other way to address the labour shortage is to accelerate modular construction, whereby houses are built in bits under the protection of a factory roof and then assembled on site. For example, Persimmon (PSN) operates an offsite manufacturing plant called Space4, which produces highly insulated wall panels and roof cassettes, which help address energy efficiency as well as requiring fewer skilled labourers. In 2017 it delivered 6,450 frame kits. The big problem here is that there is currently a lack of design variation, and customers are less inclined to be happy with just another little box differentiated from all the others by as little as the number on the front door.

Local authority building, meanwhile, is restricted by a lack of funding, but there is a growing trend towards establishing partnership agreements with housebuilders such as Urban&Civic (UANC) to build more homes at the more affordable level. This process is usually helped by the fact that the land to be built on is owned by the local authority. It’s also clear that the drive for a useful investment return is attracting more institutional funds into the market. These schemes can offer a varied end product. A housebuilder will want to sell some homes straight to the private sector, but will be in partnership to build homes for rent and part buy/part rent schemes. This looks to be the way forward, but it is still in its infancy.

 

Housebuilding heroes

So, which of the housebuilders is worth a second look? Let’s be clear. All the housebuilders will remain profitable as long as the key pillars of support remain in place. These include cheap mortgages, cheap land, high employments levels, reasonable economic growth and, of course, government largesse. All these combine to make it possible for builders to make a profit and buyers to want to buy. 

However, with a slowing market, costly incentives can increase, while benign price inflation allows rising input costs to eat into margins. Housebuilders are currently between a rock and a hard place because there is no incentive to increase output, given the weakness in the existing home market, while sales rates are strong enough not to leave a glut of unsold properties. 

Nevertheless, builders are better placed than they were just before the financial crash, with few of the top builders showing any debt on the balance sheet. And there is little chance of land values collapsing because as a commodity land remains in short supply. In fact, even if all designated brownfield sites were used to build houses there would still be a shortage of land. At the same time, the days of double-digit growth are now over. It could be argued that most of the builders have just spent the past decade getting back to where they were before the crash, but if you refer to the price/net asset valuation metric, a majority of the housebuilders are still cheaper now than they were before the crash. 

But with the annual gains seen over the past decade no longer a feature, there is a risk that sentiment will tar the whole sector with the same brush. This is unfortunate because there are some interesting companies that still offer growth potential. While prospective first-time buyers may be fretting over whether to jump onto the first rung of the housing ladder, or, in financial terms, are unable to jump that high, they will at some point have to leave home.

This is providing the stimulus for a new format, whereby institutional money and local authorities work together with builders to provide rental accommodation: so-called ‘build to rent’. This is an acceptable way of living in places like London because people can afford to rent properties in areas where they couldn’t afford to buy. Telford Homes (TEF) works mainly in the east end of London, and as well as building apartments at the ‘affordable’ end of the market is also now working in partnership with institutions looking for the long-term and relatively low-risk investment return that residential property can provide. For Telford, the attraction is the low level of risk and the capital-light properties of the business model, whereby the landlord forward funds the construction and Telford is paid through the planning and construction process. 

MJ Gleeson is another play on the need for affordable housing, and also the regional performance variations becoming apparent in the UK new-build market. It has two revenue streams, selling consented ‘strategic’ land to housebuilders in the south of England and building homes in the north. Income from strategic land sales can be lumpy as it depends on in which accounting period any deal is secured. Its own housebuilding model is much more predictable and robust because average selling prices are cheap. Two people earning the minimum wage can afford to buy these houses, and Gleeson maintains its margins by securing disused land that no-one else is interested in; typically, a small area within a council house estate. 

Another company different to mainstream housebuilders is Countryside Properties (CSP), which floated in February 2016. Approaching half its profits are generated through partnership agreements. It works with local authorities, and the business model serves both well. Affordable housing construction is managed on a forward funded basis, so Countryside doesn’t have a lot of its own capital tied up. The planning process is usually that much easier because the land used is owned by the local authority. Countryside also gets to build some private units; that’s useful for the local authority because owners of private apartments pay council tax. Social housing is not only in short supply, but is also less cyclical than the private sector, and Countryside’s social housing pipeline is big enough to keep it going for nine years. 

Urban&Civic offers another way of gaining exposure to the housebuilding sector. The company acts as a master builder and works closely with local authorities. The business model centres on gaining planning consent and then granting a licence to builders on the sites it owns. And these are big, such as Alconbury, a former Ministry of Defence site near Huntingdon covering nearly 1,500 acres; that’s enough space to build 6,500 homes. One key difference is that working closely with the local authority has greatly reduced the time it takes to gain planning consent.

It may also be worth taking a more circumspect look at the volume housebuilders. Recent warnings from builders have come from those operating at the higher end of the market, such as Berkeley and Crest Nicholson (CRST), which recently reported a drop in profits mainly because house price inflation at the higher end of the market had slowed while cost inflation hadn’t. It is now repositioning itself to operate at the cheaper end of the market, but its open-market average selling prices are still high at nearly £450,000.

Without doubt, those builders with less exposure to the high end of the market will be less affected by the slowdown. Persimmon may have attracted some attention relating to the size of director pay packets, but there is nothing wrong with the trading side of the business that has made such high incentive payments possible. As well as having its own off-site manufacturing capability, it also owns its own brick factory, and best of all average selling prices are less than £250,000. 

Bellway (BWY) is also operating at the more affordable end of the market, with average selling prices of £280,000. In a recent trading update, it revealed a rise in its forward order book, while operating margins are barely changed from a year earlier. Bovis Homes (BVS) is a special case because for many years it was a serial underperformer. However, recent management changes mean that it has been playing catch-up, while currently offering a forecast dividend yield of nearly 9 per cent. However, the return on capital employed is still well below the sector average, even though it too is targeting the more affordable end of the market.

Among the big boys that leaves Taylor Wimpey (TW.) and Barratt Developments (BDEV). Both have reported solid enough growth, and Barratt even managed to lift operating margins. Trading on a forecast 1.2 times net assets and yielding over 9 per cent, there is some very bad news factored in, or perhaps the sentiment driven 25 per cent drop in the share price so far this year leaves them looking badly undervalued.