UK housebuilders – is now the time to invest?

Safe as houses is a well-known expression. But so far this year, housebuilder stocks have been anything but.

Across the sector, share prices are down around 40% on average so far in 2022. That’s wiped out close to £17bn in shareholder value.

However, before we dive into where we are today, it’s important to understand what’s happened over the last few years.

The golden times

It’s not long-ago that markets were hit by wave after wave of positive news from housebuilders. High house prices and buyers armed with cheap mortgages helped housebuilders enjoy a set of goldilocks conditions.

Arguably the main driver of that success was higher house prices. The pandemic put the brakes on most economic activity and when things reopened there was massive pent-up demand to work through. The government also flooded the housing market with incentives like stamp duty holidays.

Average new build house price

Scroll across to see the full chart.

Source: Bank of England, 23/11/22.

House prices quickly recovered from their pandemic lows and went on to post record highs.

For housebuilders, and investors, times were good. Lots of the largest builders in the country were able to post strong revenues, bolster balance sheets and pass on the good times through shareholder returns.

But good times don’t last forever, and the housebuilding sector is inherently cyclical. That means the fortunes of these businesses wax and wane alongside the health of the economy.

What’s changed?

The first thing to remember is that markets are forward-looking. Share prices often react to what the consensus is on the outlook for a year or two into the future, not necessarily what’s happening in the here and now. Over the year, there’ve been several economic changes that mean the outlook for both house prices and buyer demand have weakened.

Affordability is the first sign of weakness. Aside from house prices being at record highs, broader inflation’s been running riot over the course of the year, and this has a few impacts on a potential buyer.

The first is a basic cost equation. If everyday costs increase then consumers have less disposable income. When it comes to making a big purchase decision like a new house, cost pressures mean some buyers will simply be priced out of taking on a mortgage.

At the start of the year, data for 2021 showed the average home in England was sold at the equivalent of 9.1 times average annual income, up from 7.9 in 2020. Buyers were already under increased financial pressure, even before the cost-of-living crisis started to really take hold.

We then have the increase in mortgage rates, which have compounded the affordability issues that we’ve already discussed. Mortgage providers look at market expectations for the base rate of interest and price their products using that as a reference point. Given the rate rises we’ve already had this year, and the expectation that the Bank of England will raise further, that’s caused mortgage rates to spike.

In the current market, a first-time buyer will be hard pressed to find a two or five-year fixed mortgage for anything under 5%. A year or so ago you could pick one up for a little over 1%.

That’s a significant drain on finances at a time when inflated house prices mean the amounts being borrowed are already sky high. We’re already seeing the impact feed through to an increase in cancellation rates for some of the major housebuilders.

The cost equation

The mix of lower affordability and higher mortgage costs are a recipe for a drop in demand. House prices haven’t made any major moves yet, but we’re starting to see weakness creep in. It’s the outlook that’s worrying markets. Recent predictions released alongside the government's autumn statement suggested we could be in for a 9% fall by the third quarter of 2024.

That poses a few concerns for housebuilders, not least of which is the fact higher house prices have been offsetting soaring build cost inflation. By and large, the major builders have been seeing build cost inflation in the high single, even double-digit range.

Housebuilders are price takers. That means they have limited ability to pass on higher costs to buyers, unless the supply and demand dynamics of the market allow it.

If prices start to fall without any reduction in costs, that’ll start to hurt margins, cash flow and ultimately shareholder returns. In that environment, the sky-high dividend yields on offer come under pressure and we’ve already seen Persimmon tweak its dividend policy to reflect the tougher climate.

Is there any good news?

As mentioned, housebuilders are cyclical businesses. Investors should be prepared for the ups and downs that come with investing in a business closely tied to the health of both the economy and housing market.

However, difficult periods can be seen as buying opportunities when investing for the long term. It’s hard to achieve the age-old adage of ‘buy low, sell high’ if you only consider investments when they’re performing well.

And so, the question becomes, has enough pain already been built into the housebuilders’ valuations for them to become attractive, even considering the obvious short-term challenges?

We see longer-term tailwinds for the UK housing market as being fairly robust. UK housing supply has fallen well short of government targets for several years. Brits are ideologically committed to home ownership and the prolonged period of housing undersupply is a trend that's unlikely to change anytime soon. That should be an underlying demand and price driver for years to come.

New build dwellings completed, England

Source: Department for Levelling Up, Housing and Communities and Ministry of Housing, Communities & Local Government 15/09/2022. Data for mid 2020s is estimated.

Over the long term, we see the sector's downtrodden valuations as looking more attractive than they have for some time.

That said, it looks all but certain there’ll be some form of price and demand weakness into next year and any worsening of the outlook will no doubt cause further volatility.

It’s in these times that the pound-cost average method of investing has its merits. That’s just a fancy term for investing regularly over a period of time, like every month.

By spreading the investment, you can limit the impact that a short-term down market might have and take advantage by buying in at lower valuations. Of course, there are no guarantees as to if and when the housebuilders’ valuations will recover.

This article isn’t personal advice. If you’re not sure what’s right for you, ask for financial advice. All investments and any income they produce can rise as well as fall in value, so you could get back less than you invest. Past performance is not a guide to the future. Investing in individual companies is higher risk, as the fate of your investment relies on one company. Any investment should be made as part of a diversified portfolio.