Housebuilders set for squeeze

Housebuilders will remain profitable but margins could be squeezed

December 13, 2018

Housebuilders have made an astonishing recovery in the past decade, ably assisted by Help to Buy, low interest rates and improved mortgage availability, not to mention a chronic shortage of houses. But is this cycle coming to an end?

The answer is probably no, although the criticisms about build quality (in some cases), excessive pay and premium pricing will probably not go away. Shareholders will continue to benefit from highly attractive dividend yields, but this is small recompense for the steady decline in share prices that took place in 2018. Because of this decline, valuations on a price/net asset value basis look considerably less stretched, but share prices are already discounting some unpleasant news that may or may not happen.

Headwinds in 2019

Unfortunately, a cocktail of caution, speculation and uncertainty will make it difficult for housebuilding shares to make any real progress in 2019. But there may be something behind the prospect of a further lacklustre performance that has its roots in more tangible influences.

House prices have outpaced wage growth by a country mile, and there has to come a time, if it hasn’t already arrived, that selling prices will be out of reach for many people. This is a contentious issue because media headlines rarely stray away from markets in London and the South East, which covers up the fact that in some other parts of the country new houses are perfectly affordable. The problem is that these houses may not necessarily be where people want to live. Regional variations make it hard to paint a broad picture on house price inflation. In London and the South East, it is nominal or negative, while prices in Scotland in the year to September 2018 rose by over 5 per cent. Inverclyde, for example, posted price inflation of 12.2 per cent to give average prices of £134,000.

For builders in and around the M25 this slowing in house price inflation is mostly a reflection of slower inflation in existing homes, where transactional volume has declined, partly because homeowners don’t want to take on a larger mortgage or, in many cases, because they can’t afford to. But slower inflation has come at a time when build costs have not really slowed much, and are still running at around 3 to 4 per cent.

Lower output

These factors all point to a slowdown in output. Put simply, builders are not going to build as many houses if there is no one willing to buy them, and a margin squeeze as builders start to ramp up the incentives such as stamp duty paid, part-exchange schemes and fitted kitchens and bathrooms. This suggests that operating margins and the return on capital employed, although still remarkably healthy, will suffer in 2019, even though builders have started to take measures to protect margins such as greater build efficiency and greater use of modular construction techniques.

One sector of the market that is likely to attract growing interest in the coming year is urban regeneration and partnership agreements. These combine a number of attractive elements because the need for social housing is less affected by cyclical swings that steer private housing construction. The idea is being spearheaded by companies such as Countryside Properties (CSP), whereby the company builds social homes on council owned land. This speeds up the planning process significantly, and the scheme usually allows an element of private construction as well. These schemes are conducted on a forward-funded basis, which means that there is less of the housebuilder’s money tied up in the project. Countryside has enough plots to keep it going for nine years at current output. Other housebuilders are also taking part such as Bellway, while costs are being addressed by rationalising the number of suppliers used and restricting the design range.

Brexit negotiations remain at a delicate stage, and even if rubber stamped there remains a degree of uncertainty. The key pillar of support for the housebuilders is the health of the economy. If growth is knocked by a shock event, such as a Labour government, it will be a case of here we go again, with unsold houses, falling prices and another culling of the workforce. This we see as an extreme option, but even if there is a pleasing outcome to Brexit and the economy picks itself up, the year ahead is unlikely to promise much more than the same again but a little less of it.

Commercial property relatively well placed to weather the storm

It’s going to be harder than usual to look into potential trends for 2019 because the commercial real estate market will be burdened with political and economic uncertainty as well as the never-ending Brexit saga.

Some sub-sectors are likely to perform better than others and, despite all the prophecies of doom enclosing the London office market, the picture is not nearly as bad as media headlines suggest. A key influencing factor here is supply – or rather the lack of it. Taking out the cranes in London associated with pre-let and residential leaves very little, which means that vacancy rates are likely to fall, and this will help to underpin rental growth. Landlords are also becoming alive to the change in working practices, and we should expect to see a greater emphasis on creating flexible working space. Overall, the West End is likely to hold up better than the City, because the current amount of space under construction is around half the average annual take-up.

Brexit blues?

A bad outcome to Brexit cannot be ruled out, and in time-honoured fashion, share prices would be marked down severely. However, many real estate landlords are already nursing deep discounts to net asset value, and with loan-to-value ratios, for the most part, at relatively modest levels, the suggestion is that most if not all business models would not be seriously threatened. However, yields would widen and rents would come under pressure, but nothing like on the scale that followed the 2007-08 financial crash.

Life outside London

Outside London and into the large regional areas such as Leeds, Manchester and Birmingham, office yields are that much higher, and as such will have less exposure to any increase in interest rates and bond yields. Supply is also constrained, although there is likely to be an increase in speculative developments given the consistent levels of demand. As such, capital value growth and total returns are likely to be better in the regions than in London and the South East. That said, some parts of the London suburbs have been significantly affected by the introduction of permitted development rights, allowing offices to be converted for residential use. In some areas, vacant office space is hard to find, offering some measure of support to rents.

Returns on industrial assets are expected to outperform just about everything else, but returns could start to slow as the level of development starts to erode the supply/demand imbalance. The key driver is a change in consumer spending habits, or more specifically, the way they spend. Demand for large warehouses to service internet sourced orders remains high, but there is also a strong need for smaller, efficient last-mile delivery centres, and we should expect to see some innovative solutions as to how these can be provided close to inner cities where demand for space from other sectors remains intense.

Retail regrets

The serial underperformer for 2019 is expected to be the retail sector – again. For while retail spending is expected to hold up well, online business will prosper at the expense of the more traditional high-street outlets. Rents have come under pressure in the face of more and more company voluntary agreements and insolvencies, with more expected in 2019 following nearly 3,000 retail stores affected by closure in 2018. Out-of-town shopping centres are likely to fare better than in-town shopping centres, but even here rental growth is expected to slow to a crawl. One sector that will show greater resilience is convenience shopping, where current trends favour more local based shops. Landlords who focus on greater interaction with tenants and with lower rental levels should be able to weather any downturn that much better.

Healthy returns

There remains one sector that is virtually unaffected by politics, or Brexit, and that is primary healthcare, where none of the current market influences will affect the number of people seeking medical advice or getting older. Building new health centres makes a lot of sense as they free up A&E units by providing a lot of the services normally only available at a hospital outside GP hours. The rent is paid by the government, which means that rental income is divorced from factors affecting other parts of the real estate sector. A lack of new building has held back rental growth, but even here, many of the rents paid are linked to inflation. Currently something of a slow burner, and no doubt likely to be tarred with the brush if Brexit worked out badly, this sector is about as bomb proof as you can get.

UK equities: relative values, external levers