George Salmon, Equity Analyst 13 March 2019
There’s plenty of division in UK politics just now. And with UK cyclical sectors – those that tend to follow the economy more closely, like housebuilders – splitting investors’ opinion, there’s a chasm developing in the stock market too.
Knocking on the door of opportunity
Housebuilders are producing more homes than ever before, and profits are hitting record levels.
Lots of the main players have years of land already secured, and can boast healthy net cash positions. This means these companies are better placed to withstand knocks to their foundations.
In fact, housebuilder balance sheets are in even better health than many imagine. Accounting practices mean most of their land is recorded at what it was bought for, rather than what it’s worth now. Inflation in the value of land means its recorded value is often underestimated.
Higher profits have helped deliver steady increases in shareholder returns. That means the builders are some of the highest yielders in the market, though there are no guarantees that will continue into the future. While much of that is due to special dividends, which could get cut if conditions deteriorate, we think the strong balance sheets should help maintain the ordinary dividend through the cycle.
Some housebuilders have embarked on share buyback schemes too. Boards deciding buybacks are more appropriate can be a sign management thinks the shares are undervalued.
To top it all off, the UK has a serious housing shortage. That’s a headache for the government, but a windfall for builders.
All-in-all, the sector’s seeing record growth while share prices are standing broadly still. So it’s fair to ask if it’s housing opportunity.
Please remember that all investments fall as well as rise in value, so you could get back less than you invest.
What’s the bad news?
There might be opportunities, but there are risks too. Three stand out.
No prizes for guessing the first. Brexit uncertainty is hurting the industry, as transaction numbers and house prices stutter. A disorderly exit, and the potential negative impact on the economy has clear potential to impact the sector.
While times are uncertain, interest rates could rise quicker than expected. Rates are still very low by historic standards, and we do expect future rises to be gradual. But if there’s a sharper rise it would impact mortgage affordability, which would likely feed through to lower prices or fewer transactions. Or both.
Help to Buy
We can’t forget the industry’s being buoyed by government schemes like Help to Buy. But this assistance is due to end in 2023, and it’s hard to know what the full impact will be when it’s gone.
Berkeley – not all problems are created equal
Most of the builders are in similar positions, but the above headwinds don’t blow equally strongly for all of them.
For example, while other builders depend on Help to Buy for a big chunk of sales, London specialist Berkeley has very little exposure to the scheme. That’s because it’s a premium housebuilder, with the average home selling for £740,000.
Berkeley reckons it has £2bn worth of land in the pipeline, and expects those sites to make £6bn in gross profit over the coming years. That’s more than its current market cap. But investors should remember there’s no guarantee of that profit appearing.
We like Berkeley’s operating model. Run-of-the-mill housebuilders are all quite similar, chasing the same customers with fairly non-distinct houses. In contrast, Berkeley has a reputation for taking on difficult sites no other developers will touch, and turning them into exclusive, and lucrative, properties.
Its approach to shareholder returns is a bit different too. Berkeley plans to return £280m to shareholders a year until 2025, through share buybacks and dividends. The decision to shift towards share buybacks means physical cash coming back will be variable, but reinvesting in the shares is a sign of management’s confidence.
But for all its good qualities, Berkeley is very exposed to Brexit headwinds. The London market is more sensitive to economic uncertainty, and signs of a slowdown are already creeping in.
Overall, we think Berkeley’s track record for quality, unique developments will hold it in good stead in the long-run. But investors should be prepared for a bumpy time in the shorter-term, particularly if Brexit continues to make conditions in London uncomfortable.
Taylor Wimpey – sometimes less is more
If you’re not convinced by Berkeley’s luxury London homes, Taylor Wimpey could be one of the sector’s better options.
Taylor builds more ‘regular’ houses, which sell for an average of £264,000, all across the country. And it’s building these homes at improved margins, resulting in a record full year pre-tax profit of £857m.
The lower selling price means it’s much more exposed to first time buyers. In 2016 home ownership among 25-34 year olds was just 27%, meaning there should be plenty of pent-up demand when it comes to getting on the property ladder.
But we can’t deny the end of Help to Buy in 2023 is likely to have a short-term impact on new build demand. As it stands, 36% of Taylor Wimpey’s sales use the scheme. Until 2023 comes we won’t know what the full effect of the change will be.
For those prepared to wait and see what happens, Taylor offers a prospective yield of 10%. Around two thirds of that comes from special dividends which could be cut if the going gets tough. The ordinary component looks more stable to us. Yields are variable and are not a reliable indicator of what you might get in the future.
The group’s worked hard to become more profitable, and people’s desire to own property is deep-rooted. We think Taylor’s primed to keep delivering affordable homes to those that want them, providing the wider market behaves itself.
Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.
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