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Britain’s Building Boom



Britain’s Building Boom

Having spent five years scaling back operations as the recession took hold UK house builders are reaping the rewards of an upturn in the economy and a chronic housing shortage. And it’s hard not to remain bullish about the UK housing market, with major builders currently enjoying some of the most favourable conditions since before the recession. Mortgages are now more widely available, and cash strapped first-time buyers have been given a leg onto the first rung of the housing ladder with a string of mortgage subsidies including Help to Buy.

On top of this, and despite solid progress in raising output, demand for houses still exceeds supply by a country mile – with no end to the imbalance in sight. It's been suggested that we can expect a shortage of around a million homes within a decade as the number of households continues to rise – it’s said that nearly a fifth of women and a third of men between the age of 20 and 34 still live at their family home, and 221,000 new households are being created every year as they fly the nest, according to figures from the Office of National Statistics. Housing construction, however, is running at around 100,000 new homes a year, well below the levels seen at the peak in 2007 and, more importantly, less than half of the number that will be required to offset the shortfall.

Housing construction trends (quarterly completions)

How long can this ideal demand picture last? The consensus opinion is for some time yet – hence our positive views on the house building industry despite an average 240 per cent rise in their share prices over the last five years. The next potential hurdle is the May 2015 election, but whatever the cocktail of politicians taking the helm, and despite all the misguided rhetoric about builders hoarding land, it’s unlikely that a new government will be willing to rock the boat. Higher interest rates remain a distant worry, but there seems to be little on the inflation horizon to justify an increase – and that should mean mortgage approvals continue to tick up from the current low level of around 70,000 a month, well below the 2007 peak of closer to 100,000.

And warnings of a housing bubble are some way wide of the mark, almost as if, having completely missed the last downturn, forecasters are trying to be early on the next one. Recent numbers from Bellway (BWY) highlight the point. Average selling prices last year rose by 13.1 per cent, but none of this was attributable to inflation - it was simply the result of a shift in production more towards the prosperous south of the country, where house prices are higher. The average UK house price is back to its pre-crash peak, although the recovery across the UK has been uneven, with soaring London offset by more muted regional price appreciation – another key argument against the prospect of a new house price bubble being formed.

UK house prices

No peak yet

Put simply, while the cycle has turned definitively upwards after an unprecedented slump in 2008, we are nowhere near a peak in the house building and broader construction sector. Breedon Aggregates – the Aim-traded supplier of bulk materials to civil and residential construction projects - said that demand for its products had fallen 35 to 40 per cent since 2008, and it believed 2012 marked the low point in the cycle. While housebuilding activity is unlikely to catch up with demand, it is rising fast – the Markit/CIPS UK construction PMI hit 64.6 in January, way above the reading of 50 that signifies a swing into expansion. And house builders will be happy to continue gearing up output while government incentives remain in place to assist first-time buyers and while interest rates and land prices remain low.

However, while those benign conditions will continue for some time they won’t last forever. With demand exceeding supply the perpetual dream of managing to balance housing demand with sustainable affordability could be a tough one to achieve – not least as there are early signs that construction cost inflation could be on the way, too.

These are important considerations for would be investors in the sector as up to 60 per cent of the price of a house is labour and material, and house builders are already looking at ways to mitigate this to keep profitability ticking up despite cost inflation, but face a difficult balancing act in the years ahead. One way would be to increase selling prices – thus a 5 per cent rise in labour and material costs could be recouped easily through a 2.5 per cent increase in the selling price.

However, in the last 40 years the average house price/salary ratio has nearly doubled, and there are unsurprisingly concerns that stretched affordability could stop the recovery in its tracks. Already social housing waiting lists have doubled in the last decade, with nearly 5m people waiting for a home – the need to satisfy this demand, combined with cost pressures from elsewhere, could feasibly put a dampener on housebuilders’ operating profit margins which have expanded steadily since 2008-09 but which remain substantially below the peak of closer to 20 per cent.

Operating margin expansion

2007 2008 2009 2010 2011 2012 2013
Barratt Developments 16.9 15.5 2.4 4.4 6.4 8.5 11.0
Bellway 18.7 16.1 6.7 6.9 10.1 12.8 15.6
Berkeley 19.5 20.8 17.8 17.4 17.4 19.6 20.7
Bovis 23.1 22.8 7.5 6.2 10.0 13.4 14.9
Persimmon 21.8 11.3 4.0 8.2 10.0 12.9 16.0
Taylor Wimpey 13.7 2.2 5.8 11.2 9.0 11.5 13.1
Average 19.0 14.8 7.4 9.1 10.5 13.1 15.2

Source: Company accounts

Skill shortages

Despite the strength of the housebuilders’ recovery, the scars of the recession are still there to see, not least among the skilled workforce employed by sub-contractors and the suppliers of building materials. In the last four years a quarter of all plumbers, around a fifth of bricklayers together with joiners and roofers have left the industry for good either to retrain or retire. That equates to 350,000 skilled workers leaving the industry. At the same time, construction apprenticeships have also fallen, although some house builders are placing apprentices with sub-contractors to learn a trade.

For those tradesmen left behind, it would seem that Christmas has come early as demand outstrips supply. According to consultancy group EC Harris, the tipping point between negative and positive build cost inflation, initially forecast to be reached later this year, has already arrived. Cost inflation across the whole construction industry is forecast at 4 per cent for this year and next year. And with the biggest contribution coming from the more buoyant house building side, it is likely that cost inflation within the housing sub-sector is considerably higher.

Further evidence of growing pressure comes from the latest finding from employment agency Reed, where vacancies on its website in January rose 74 per cent for construction and property related jobs. Recruiter Hays

(HAS) has 2,100 jobs advertised at present. And in the third quarter of last year, a third of all construction companies reported problems in finding sufficient skilled labour, according to the Royal Institute of Chartered Surveyors. Wage inflation for bricklayers, as an example, is currently running at around 10 per cent – with many also working on short-term contracts that mean they can move employers with relative ease.

There are also competing pressures for labour from government funded projects. Demand for skilled workers is also being boosted by a belated appearance of the government’s infrastructure spending initiative. Drilling tunnels for Crossrail, for example, is set to finish this year, and this means that contractors on public infrastructure and large commercial projects will be looking for a small army of skilled workers associated with fit out, like electricians. Other large redevelopment projects include Nine Elms, the proposed Thames Tideway tunnel and the redevelopment of Earl’s Court. Investment under the National Infrastructure plan will rise from £309 billion last year to over £375 billion over the next few years, with much of the investment going towards transport and energy.

This could mean that the smaller private contractors that have much more exposure to residential construction projects will be able to become more selective about what work they take on, an option that did not exist during the recession. This is pretty much the position that applies to the major house builders who contract out the construction work. It’s worth noting though that the country’s top eight house builders account for only around 35 per cent of the new houses built each year. The rest come from smaller private companies all the way down to the local builder who will build one or two houses a year.

Material concerns

On the materials side, the suggestion of cost inflation is harder to justify – for now. For a start, house building makes up just 15 per cent of total construction output, and while plans for central government infrastructure spending have come thick and fast, few of them, so far, have translated into shovels in the ground. Arguably, this could change in the next fifteen months as the economy improves and a general election approaches, but for now the increase in demand for materials is not putting that much of a strain on suppliers, as meeting the increased demand can be achieved meanwhile through the greater use of imports.

Using bricks as an example, brick sales in November last year were up 27 per cent from a year earlier, but brick makers coped with this by tapping non-UK sources. Even so, imports in the third quarter of 2013 jumped by 39 per cent. This is a short term fix as manufacturers gear up production, but as yet, there is little scope to increase prices, not least because the last six years have been spent running down an estimated 1.1bn brick stockpile to a current level of around 332m. Unsurprisingly construction firms are now much more interested in securing a supply of bricks for their projects, and the benefits are just starting to show through. Output at Michelmersh Brick

(MBH) for example – which controls 5 per cent of the UK market - last year rose by 12 per cent to 71.5m bricks, and average selling prices were up from £343 per thousand to £348. It has plans for limited capital expenditure until such times as margins start to recover – which suggests higher prices could be on the way.

Tellingly, and contrary to normal practise, prices for 2014 have not been fixed. Chief executive Martin Warner reckons there has been a complete sea change in the last few months, with contractors more worried about securing a supply than pricing. “Sitting on a building site for two days waiting for bricks to arrive can be an extremely expensive business”, he added. The same is likely to apply o suppliers like Breedon Aggregates

(BREE), the UK’s largest independent aggregates business with around 400m tonnes of mineral reserves. The acceleration in demand is reflected in higher sales of aggregates, ready-mixed concrete and asphalt, and for the current year, the Mineral Products Association is forecasting 2-4 per cent growth in aggregate volumes, 3-5 per cent in ready-mixed concrete and 2-4 per cent in asphalt – the most positive outlook for several years. After five years of subdued demand, suppliers hold the whip hand – according to RICS, 40 per cent of builders said they are facing delays as a result of difficulties getting hold of materials.

Meanwhile, manufacturers do not see capacity constraints as being an issue, according to a survey by the Construction Products Association. In fact, over the next 12 months only 24 per cent of heavy side and 25 per cent of light side manufacturers expect to be operating at 90 per cent capacity or above. However, their margins are expected to remain under pressure, with over 80 per cent of manufacturers reporting a rise in fuel costs and three quarters an increase in energy prices. That, too, could find its way through into additional build costs.

Use it or lose it

Another potential source of pressure on margins is the cost of land. Most housebuilders benefited from cheap land acquired during the post credit crunch slump, and have been ploughing through this as the market has roared back into life. Land banks have shrunk by 20 per cent in the last five years, and 63 per cent of consented plots are actually under construction. Of the remainder more than half are economically unviable.

In the short-term, this is unlikely to be a worry as most major builders carry a land bank worth around five years of production. Contrary to some political assertions, this is not hoarding, more an indication that planning procedures simply take too long – despite views of new build estates blighting Britain’s landscape, only 2.27 per cent of England is concreted over, and between 2000 and 2010 new housing accounted for just 0.13 per cent of England’s land area. And around 80 per cent of new homes are built on brown field sites, although local opposition to brown field development can be just as strong as for green field sites.

Even so, pressure remains to enforce the ‘use it or lose it’ policy on land ownership – which means developers are unable to simply sit on development land and hope that its price rises in value. Whatever the case, house builders will need to replenish their land banks, and the cost of doing so will rise at some point.

However, it is not a given certainty that prices will rise to the extent where margins come under real pressure. This is because some house builders, like Taylor Wimpey, reckon its land bank of 70,000 plots is enough, and will only be topped up in order to replace what is being used. Naturally, a less aggressive stance on land buying will take off some of the upward pressure that would inevitably develop if builders continued to boost their land banks at the same pace as over the past few years.

So why have access to as much as five year’s supply of land? Does this amount to hoarding land and waiting for the price to rise? Exactly the opposite in fact. Tying up capital in a land bank for speculative gain is not in the business model of any house builder, and the size of the land bank reflects the lengthy planning process. Some plots form the strategic land bank. This is land where the builder has no planning consent, and efforts will be made at some point to ‘pull this through’ into the consented land bank. After outline planning permission has been granted, the fine work starts on gaining final consent, and this will involve work with local authorities to cover Section 106 requirements, typically an obligation to include an element of social housing, and other discretionary elements like playgrounds or other community spaces. All this can take years and explains the need for a long inventory of building plots.

Housebuilders are nevertheless exploring other ways to reduce costs and speed up production to offset these unavoidable costs of doing business, embracing new construction techniques such as modular construction. The very mention of this sets many people harking back to the pre-fabs built on east London bomb sites after the Second World War. Times have changed however – new modular construction techniques are of extremely high quality, and the attractions of using off-site construction are significant. Houses are built in a clean factory environment, so there are no weather related delays. Insulation and other environmental essentials are of a very high standard, while conventional building materials are still used. Construction can take place at the same time as the site is being developed, and the time saving is considerable. Recently listed Mar City is one small housebuilder employing such techniques, but larger housebuilders are too – although it remains a relatively small proportion of overall construction.

Housebuilders: building the investment case

Arguably, though, the shortage of skilled labour will be much harder to address, and without an inflow of imported labour, upward pressure on wages will continue. With house builders unlikely to want to see their margins squeezed, this will find its way into higher selling prices. It’s worth pointing out that new houses account for just 10 per cent of annual transactions, and prices tend to follow trends established in the already built housing market – which means that, ultimately, whatever the cost pressures, rising selling prices should help house builders continue their recovery.

That should come as a comfort to investors in the sector, because all major house builders now trade at a premium to net asset value, which in a normal market would make them expensive on valuation grounds. But this is no normal market, with cheap money, cheap mortgages and huge demand. So with all builders delivering top rate performances, those that offer the best return remain our favourites. These include Persimmon

(PSN) and Berkeley Group
(BKG) both of which have promised to return funds to shareholders, and both of which are currently paying dividends in excess of 5 per cent. We also like smaller, more nimble builders such as Inland Homes

How the UK's housebuilders compare

Name Ticker Price (p) Market cap (£m) 5-year change (%) 1-year change (%) 3-month change (%) Forecast PE ratio Dividend yield (%)* Price to book value (x)
BARRATT DEVELOPMENTS BDEV 413 4060 609 50 18 14.3 1.4 1.3
BELLWAY BLWY 1660 2026 145 28 6 11.9 2.2 1.7
BERKELEY GROUP HDG.(THE) BKG 2620 3546 195 28 -1 13.6 5.7 2.6
BOVIS HOMES GROUP BVS 896 1201 114 21 13 12.2 1.5 1.5
CREST NICHOLSON HOLDINGS CRST 393 989 NA 33 8 11.3 1.7 4.6
GLEESON (MJ) GROUP GLSN 405 215 474 99 26 22.9 0.8 2.1
PERSIMMON PSN 1346 4102 317 35 9 12.4 0.0 2.0
REDROW RDW 326 1204 205 73 4 13.6 0.6 2.0
TAYLOR WIMPEY TW. 118 3823 648 30 6 11.9 0.6 1.7
INLAND HOMES INL 48 98 589 79 3 15.1 0.6 1.7
GALLIFORD TRY GFRD 1327 1091 358 45 14 15.7 3.0 2.2
TELFORD HOMES TEF 347 206 1534 65 1 14.6 1.9 2.4
MAR CITY MAR 143 158 281 694 47 17.0 0.0 30.3
TRAFALGAR NEW HOMES TRAF 3.4 7.7 35 170 -10 6.9 0.0 -5.3
Source: Thomson Datastream

*Does not include special dividends

Polypipe's promising prospects

Timing is everything, and the UK’s largest manufacturer of plastic piping systems Polypipe has decided the time is right to test the waters with an initial public offering to trade its shares on the main London stock market. Founded in 1980, the group operates out of 16 facilities, and has a useful revenue mix split roughly half in half between the residential market and commercial, civil and infrastructure. It also operates in France and Ireland, with a presence in Italy and the Middle East too.

The improving economic climate has boosted demand, but Polypipe has also achieved a steady increase in market penetration as legacy materials such as copper, cast iron, concrete and clay are replaced with more modern plastic systems. There has also been some follow on demand resulting from more stringent environmental legislation designed to tighten up on wastage. Furthermore, plastic pipe penetration in the UK is among the lowest in Europe.

The group now boasts over 20,000 product lines, and has invested around £130m since 2005 to establish state-of-the-art manufacturing systems using a high degree of automation. The point here is that output can be increased without any further significant investment. There are also significant barriers to entry, not least the high shipping costs relating to importing what are often quite bulky products.

Terms of the flotation are expected to be released shortly, and the shares on offer will come through part realisation of existing investors in the company including group employees and the company’s principle share holder Cavendish Square Partners. No new shares will be issued in connection with the offer, but further shares may be sold by Cavendish through an over-allotment option. Last year Polypipe generated sales of £301m and adjusted cash profits of £54m, giving an adjusted operating margin of 18 per cent.

Polypipe’s birth as a publicly-listed company comes at a time when the Construction Products Association is estimating that spending on roads, water and sewage, electricity and rail is expected to grow by 8.3 per cent this year, and rising in 2015 by 18.2 per cent. And on the house construction side, output is expected to grow to pre-recession levels some time next year. Given its strong position as the UK’s leading plastic pipe manufacturer, the company could be an interesting one to watch.

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