As safe as houses:
• Interest rate danger overstated
• Prudent utilisation of land banks
• Continuing strong yields
The question of how the level of interest rates will affect the housing sector is much debated, and pushing rates higher has been suggested as a means of moderating the rise in house prices. This is dangerous territory, especially outside London and the south-east, where house price inflation has barely kicked off. Raising interest rates also runs counter to the government’s desire to help people onto the housing ladder by using Help to Buy. Helping people onto the housing ladder by making it more expensive to do so looks counter productive.
What effect will higher interest rates have on the share price performance of the major house builders? Clearly, share prices will fall initially as some investors crystallise gains made over the last couple of years. However, looking back, it’s interesting to note that the house builder sector continued to outperform the midcap index when the economy was recovering, despite an expected rise in rates. This happened following the 1990s recession, after the mid-90s double dip, and even after the dot.com collapse.
The key point here is that the outperformance reflected a general economic improvement, growing consumer confidence and rising wages. A noticeable increase in average earnings has yet to kick off this time round, but the huge outperformance of house price inflation relative to wage inflation has not been as damaging as it could have been, simply because the cost of borrowing is so low. The other point is that interest rates are not going to rise quickly or by much. Any rise chips away at disposable income, but a lot of mortgages are on two or five-year fixed terms. Add to this the fact that in London, for example, a third of all house purchases are cash transactions, and it becomes less certain how much affect a half point rise in interest rates would have; perhaps more on sentiment than wallets.
Analysts at HSBC Global Research have made some interesting projections. For example, they suggest that the Bank of England base rate would have to rise to 2.5 per cent (currently 0.5 per cent) before affordability returns to the long-term average. At the moment, this long-term average suggests that mortgage payments as a percentage of income are around 34 per cent; but right now they languish nearer 25 per cent. What’s more, base rates would have to increase to 5 per cent before affordability deteriorates to pre-crash levels. In both cases, HSBC assumes annual house price inflation of 5-6 per cent and 2 per cent nominal earnings growth through to 2017. In short, shares in house builders are expected to outperform the midcap index as long as changes in interest rates are gradual and anticipated. Put another way, a sharp correction in share prices would most likely occur only if markets felt that the Bank of England had fallen behind the curve and was obliged to slam on the brakes by pushing interest rates sharply higher in one move.
There has also been much debate on how the recommendations made by the Bank of England’s Financial Policy Committee to curb excessive mortgage lending could affect the house builders. The plan is to restrict mortgages with a loan-to-income (LTI) ratio of more than 4.5 times to just 15 per cent of the loan book, but most lenders currently operate below this limit already. The other recommendation is that lenders should include stress tests to establish lenders’ ability to pay if interest rates rise. But most mortgage providers are already applying stress tests on the assumption that rates rise to 7 per cent.
House price inflation
|Build cost inflation|
|Price (p)*||2014||2015||Thereafter||2014||2015||Thereafter||Build-out valuation (p)||Upside|
Source: HSBC calculations; *prices as at 7 Jul 2014
For the house builders, the current climate continues to favour sustained growth for a couple of years yet. True, the boost to margins from using up legacy land and building on more recently acquired cheaper land is finite, but turnover and profits are increasing as more sales outlets are opened up. Many of the house builders have also adopted a more prudent approach to acquiring land. A suitable buffer is essential in all inventories simply because of the continuing dysfunctional planning process that slows up the whole building procedure. But some builders are now handling their land banks on a top up basis, simply replacing what they use. This is important because if there are signs that the aggressive land bank expansion of recent years is starting to moderate, this could act to ease land price inflation. Furthermore, builders are sticking to their own hurdle rate objectives on land purchasing, which effectively rules out buying land that compromises margins and return on capital.
HSBC has calculated a discounted land bank build-out valuation for each house builder. This is a conservative measure because it is modelled on the assumption that builders use up their existing land banks and buy no more land. This is clearly not going to be the case, but as the table shows, even on this conservative basis, nearly all the share prices offer significant upside.
Of course, you can’t get away from the fact that house building is a cyclical event, but exploring the reasons behind the last apogee provide little indication of how or when the next peak will arrive, notably because checks and balances are already in place to prevent mortgage lending getting out of hand. Higher interest rates will help to moderate demand at some point, as would another economic downturn. Both are not on the radar screen in the short-term. And with the current trend looking good for at least another couple of years, even if growth levels moderate, share holders can enjoy some of the best dividend yields available.
Persimmon (PSN), for example, announced last year its intention to return the equivalent of 620p a share by 2021. The share price since then has risen by around 45 per cent, but the payout still equates to an annual yield of 6 per cent. Much the same is on offer at Berkeley Group (BKG) where a similar scheme promises to deliver an annual yield also of 6 per cent out to 2021. And more recently, Taylor Wimpey (TW.), boosted by cash flow generated by a replacement only land bank policy, is proposing to pay special dividends equivalent to over 5 per cent a year.
Foundations are being undermined:
• A tightening mortgage market
• Earnings multiples look expensive
• More stringent capital requirements
The latest trading updates from house builders have, without exception, painted a picture of fast-rebounding volumes, contained house-price inflation, extensive land banks and rock-solid balance sheets. The question investors need to grapple with is not whether these companies are in rude health – they are – but whether the outlook will continue to improve at a rate that justifies the valuation of their shares. The prospect of rising interest rates and a tightening mortgage market suggests not.
So are valuations expensive? Not if you look at earnings-based valuation measures. Shares in Barratt Developments (BDEV), for example, trade on about 9 times expected earnings for the next 12 months. Dividend yields across the sector are correspondingly generous.
The problem with earnings-based measures is that house builders make volatile trading profits, not the kind of recurring earnings that lend themselves to valuation multiples. And if you think a P/E ratio of 9 is ‘cheap’, you haven’t looked at the history. Eight years ago, in mid 2006, as the last housing boom was approaching its climax, Barratt shares traded on 8 times forecast earnings.
This is why analysts, until recently, have tended to focus on price to tangible book value (see chart, below). This makes the house builders, which were stock market darlings last year, look expensive. Even after the recent sell-off, their shares trade at about 1.5 times book. That’s down from the peak of about 1.8 times reached in early March (and at the end of 2006). And it’s also skewed by unusually high ratings for sector heavy-weights Persimmon and Berkeley Group, which plan to return swathes of cash to shareholders. But it hardly suggests now is a compelling time to buy.
Most analysts blame the latest sell-off, which started in March, on Mark Carney. This year the Bank of England governor has issued a plethora of mixed – but on balance increasingly hawkish – messages, not least on the housing market. The confusion was partly cleared up by the Financial Policy Committee’s decision last month to impose some very soft limits on mortgages at high income multiples. House builders were quick to welcome the measures as “reducing the risk of overheating and increasing the long-term health of the market”, as Taylor Wimpey put it in a trading update.
But the bigger worry – rising interest rates – is unlikely to disappear so fast. Mr Carney’s policy of “forward guidance” has included talk of a “new normal” of rates at about 2.5 per cent until 2017. But he has also made clear this is not a policy commitment, and last year’s forward guidance based on the unemployment rate has already been ditched.
Moreover, one of the reasons the Bank has cited for keeping its headline rate low is that lenders now need to charge a higher spread over their funding costs to account for more stringent capital requirements. In other words, the Bank rate is no longer the clear mortgage benchmark it used to be. More instructive than Mr Carney’s forward guidance may be the fact that the Bank wants lenders to ensure borrowers could afford mortgage rates at 7 per cent.
The 7 per cent rule is already in line with bank practices introduced earlier this year as part of the Mortgage Market Review (MMR), a major package of reforms aimed at consumer protection. The combination of the MMR and the prospect of rising rates is already dampening demand. In May, mortgage approvals for house purchase were at their lowest level since last August, and surveyors’ reports – historically a useful forward indicator – suggest market activity in June was at its most subdued since the autumn of 2012.
The house builders are confident none of this will affect their business, and perhaps they will be proven right. The housing market outside of London is only in its second year of recovery, and the new-build sector benefits from cross-party political support. A few catch-up stories aside, however, the shares offer neither value nor momentum, and the comparatives will only get tougher. The sector is hardly due a crash, but a protracted period of adjustment looks all too possible.