The UK’s housebuilders would seem to be entering 2020 in a less precarious position, following the Conservative Party's election victory. That follows a year when the solid house price inflation that has buoyed transaction volumes abated, uncertainty intensified over the government’s help-to-buy scheme and building material costs were elevated. That is all apart from Brexit uncertainty encouraging hesitancy among house sellers.
Those focused on building homes at the higher end of the market and in the south-east of England have been most hurt by slowing price growth in 2019. In October, Crest Nicholson (CRST) revealed it was cutting profit guidance for 2019 and 2020, citing a deterioration in London sales that forced it to write-down around £10m of the value of its legacy sites in the capital. A more prolonged and dramatic reduction in housing transaction volumes puts housebuilders at risk of a fall in the value of land held on housebuilders’ balance sheets. Meanwhile, high-end housebuilder Berkeley (BKG) this month reported that operating profit had fallen by a third over the six months to October due to a decline in the number of sales and a 13 per cent fall in the average sale price.
Yet will a Tory majority – and the greater certainty that the UK will leave the EU on 31 January – provide a boost to flagging house prices? The market's reaction to the news would suggest so, with shares for some of the largest housebuilders rising by double digits following the election result. However, that depends on whether you view slowing house price growth as a cyclical correction rather than a symptom of Brexit uncertainty. For the London housing market – the epicentre of the slowdown – affordability has also been an issue for stuttering transaction volumes. It is also worth considering that house price growth started slowing pre-referendum, at the start of 2015.
Admittedly, November house prices across the country already bounced back from two consecutive months of contraction, posting 2.1 per cent growth on the same month last year, according to the Halifax house price index. Managing director at the lender, Russell Galley, cited factors including improved mortgage affordability and a shortage of new stock coming to the market as prompting the rebound. However, the question remains as to whether that boost has extended to London and the south-east. The most recent price data from the Office for National Statistics (ONS) revealed London suffered the largest reduction in house prices in September at 0.4 per cent, followed by east England at 0.2 per cent.
Sluggish house price growth has been outpaced by the rising cost of building materials, with construction prices increasing by 3.3 per cent on an annual basis in September, according to the ONS. That has squeezed margins for many of the sector’s constituents this year, an effect that could well be repeated in 2020 unless there is a notable pick-up in sales prices.
Since 2013, the government’s help-to-buy scheme has provided a boost to margins for the largest housebuilders, a fillip that will be limited to first-time buyers only from 2021 and could be removed altogether two years later. The scheme – which enables buyers to put down a 5 per cent deposit and receive an equity loan worth up to 20 per cent of the value of the house – accounted for more than half of private completions by Persimmon (PSN) during the first half of the year and 40 per cent of reservations for fellow FTSE 100 constituent Taylor Wimpey (TW.).
However, in the event of any market collapse it seems likely that the government will be quick to support the sector by either reimplementing this scheme or a similar one to stimulate the market, argues Goodbody analyst David O’ Brien. “This therefore makes the UK housing market comparatively more favourable than other industries from a risk-reward perspective,” he says.
Both of those groups have shelled out impressive dividends to shareholders during that time, including annual special cash returns over the past four years. However, judging by the yields offered by shares in Persimmon and Taylor Wimpey, the market does not believe the level of these returns is sustainable.
Falling private sales rates has prompted some housebuilders to shift towards completing more affordable housing in partnership with housing associations and other registered providers – a trend that looks set to continue into 2020. However, while that type of work aids returns on capital, it also carries lower margins. The question for investors is, to what extent is a heightened level of risk reflected in the valuations attached to shares in UK housebuilders? We would argue not. For instance, Persimmon's shares trade at around 2.6 times forecast consensus book value at the December 2020 year-end, compared with a cyclical historical average multiple of 1.9. FTSE 100 peer Taylor Wimpey’s shares – at 1.7 times consensus price to book – are also at a premium to their 10-year average. We think the market has got carried away.
Mortgage lenders: the dogfight continues
In 2020, domestic UK bank stocks are likely to remain stuck between a rock and a hard place. The hard place – as it has been for several years – is the mortgage market, which is locked in a brutal price war. The rock – in ways both immovable and reassuring – is a regulatory environment that compels this relatively safe category of lending.
For the largest in this group, you might also call it a Catch-22. Rules introduced at the start of 2019 forced some banks – most notably HSBC (HSBA) and Barclays (BARC) – to separate their domestic retail business from international and investment banking operations. This ring-fencing exercise limited options to redeploy chunky deposit bases, effectively leaving lenders with little choice but to double down on secured personal lending, which is dominated by residential mortgages.
As of September, 67 per cent of banks’ loans fell into this category. According to the European Banking Association, the proportion of residential mortgages in the UK’s non-financial loan book is higher than any other European nation.
It’s also increasingly low-margin business. According to financial data provider Moneyfacts, recent rises in the price of interest rate swaps – which banks use to hedge themselves against movements in interest rates – have not been reflected in the average fixed rate mortgage. While some lenders can apparently choose market share over interest income, others can’t. Tesco Bank cited these pressures and “limited profitable growth opportunities” last May when it announced it would pull out of new mortgage lending altogether. It later sold its £3.8bn loan book to Lloyds Banking (LLOY).
Over the coming year, lenders who are highly dependant on net interest income, such as Virgin Money UK (VMUK) – and to a lesser extent, Royal Bank of Scotland (RBS) and Lloyds – are fighting to simply preserve margins. Metro Bank (MTRO), which has desperately battled at the top of the savings and mortgage rate league tables this year amid all manner of corporate issues, is in a problem category of its own.
One might ask whether the coming year could herald a shift into more lucrative kinds of lending. In some ways, these avenues have either been exhausted, or explored. In the case of Barclays and HSBC, significant portions of their assets are already geographically and structurally diversified. Big fees from higher-risk consumer lending has enabled Lloyds to maintain the size of its mortgage loan book while absorbing the associated margin pressures. RBS recently started talking up its ambitions to support poorer UK regions by issuing so-called “social bonds”.
Mortgage lenders can at least point to robust asset quality. The ratings agency Moody’s cited this as a strength of UK banks, despite a recent downgrade in its outlook for the sector, and a slight increase in the proportion of new mortgages with a loan-to-value ratio above 90 per cent. If anything, risky lending is declining, as tighter regulation and falling lender appetite has hammered the outstanding stock of interest-only mortgages. For Moody’s, the likelihood that the UK and EU will reach a Brexit deal is also likely to support house prices.
Other features of the UK economy provide a reassuring backdrop. The year will begin with unemployment at record lows, and interest rates at 0.75 per cent – both of which suggest credit quality is strong and borrowers can be relied on to pay their mortgage instalments.
However, none of this is to argue that mortgage lending in the UK is what you’d call an investment opportunity right now. Except for Barclays (with its diverse business lines and clear cost-cutting goals) and Paragon Banking (PAG) (whose edge in the more lucrative buy-to-let market has been carefully preserved), few mortgage plays scream value right now. AN
