Since the Brexit vote, the UK homebuilder index has fallen by 30% reflecting concerns that the UK economy – and the UK housing market – are headed towards negative growth.
The market is right to be worried. It’s pretty tough to argue that if the UK heads into recession the housing market won’t be significantly impacted. The reaction is no surprise when you remember the scale of carnage for the homebuilding sector in the previous downturn where share prices fell on average by 90% and many companies had to turn to rescue rights issues. To work out where we stand today it’s important to understand the sector’s business model and what went wrong before.
Put simply, homebuilders buy land, develop and sell houses and pocket the profit. The price paid for the land tends to be the balancing figure in a calculation of the return a homebuilder wants to make, so if they are targeting a 20% return then the land price will drop out working back from sales price and cost input assumptions. However, in 2005-7 complacency had set in, house prices had only fallen once since the nineties and people had forgotten what a crash could look like. House price inflation was adding to profits and the competition for land was increased both by new entrants and government policy limiting land availability. Homebuilders became less disciplined with return calculations when buying land and exacerbated the problem by taking on more and more leverage.
When prices fell 20% and transactions by 40% this left the homebuilders with significant declines in profits, land writedowns, very high leverage and in some cases rescue rights issues. Since the 2008 trough, the homebuilders index had risen over 800% pre the Brexit vote announcement benefitting from a far less competitive land market as many small and mid-sized homebuilders failed to get back into the market due to a lack of financing. Land policies have loosened and the government has introduced policies to encourage home ownership. House price inflation has been an outcome and has obviously helped. Crucially, homebuilders have shown increased discipline with most declining to chase growth and instead focusing on ensuring 20-25% returns through disciplined land purchases. In 2015 in England, only 140,000 new homes were built, compared to over 180,000 in 2007 and government hopes of c.220,000. This has left homebuilders in a much better financial position with the majority now operating with a net cash position compared to significant leverage in the past. A number of homebuilders have also committed to continue paying out their dividend even in the event of a significant downturn.
As for house prices, anyone who has bet against the housing market in the UK over time has come a cropper, and with significant government support from Help to Buy through to 2021, limited space and (hopefully) at some point again a growing economy it would be brave to bet against them again in the medium term. The potential for lower interest rates following Brexit will also help affordability ratios. However, the lenders’ appetite to continue lending at current rates and on current income ratios remains the key question mark. The following charts from Redburn show that while loan-to-income multiples in the UK are back to pre-crisis levels, mortgage payments as a percentage of post-tax income are at a manageable level and likely to remain so through to 2018 helped by lower-for-longer interest rates.
As with all these situations the question is what is being priced in? Recent research by Redburn suggests that housebuilder shares are pricing in a lot of negativity already. Redburn’s negative scenario is for house-price declines of 10% and transaction reduction of 20% (both half the level of what was seen in the financial crisis). In this scenario, if the homebuilders simply built out their existing land bank from the end of 2015, and never bought or developed any more land the average Build Out Value (BOV) would be only 15% below current share prices. Under a more realistic scenario where there’s a 5% price decline, and 10% fall in transaction volumes followed by normal continuation of business in a steady recovery, Redburn sees a 2020 BOV on average 44% ahead of current share prices.
In investing it’s seen as dangerous to assume “it’s different this time”. But this time, for homebuilders at least, it really might be.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.