UK Property, Part 2 – 28 May 2014
Home Builder Share Prices Dislocated from Reality
While events outlined in part one of this report have led to our conclusion that the share prices of UK home builders have become dislocated from reality, we begin the second half with a question. What does this mean for individual home builder shares and how can investors continue to leverage the supply and demand disparity in UK housing?
The short answer is that this does not automatically make all property or housing-focused companies redundant from the realm of opportunity. In the latter half of this report, we briefly review some of those that we feel are positioned to benefit from the changes as well as those that may remain immune to them.
- Bovis Homes Group Plc
- Barratt Developments Plc
- Berkeley Group Holdings Plc
- Countrywide Plc
Recap and the Road Ahead
Although the economic recovery has been positive for many reasons, it has now led to shifting interest rate expectations among policy makers and the public. From a financial stability perspective, this is likely to increase the regulatory focus upon the degree to which consumers are leveraged, while increasing the relevance of the April 26 MMR changes.
At present, signs have begun to emerge that the mortgage market may be nearing a point where it can be described as overheated. This is as Bank of England data for Q1 2014 shows loan to income ratios reaching historically high levels of an average 4 X annual income, while loan to value measures have, on average, began to retrace toward their 2005 and 2006 peaks.
For these reasons, we expect quality standards when it comes to the underwriting of new loans to tighten over the months ahead, which will be certain to exacerbate the decline in new mortgage approvals that took place throughout March and April this year.
Although this is likely to be a voluntary action by the financial sector, if the Financial Policy Committee at the Bank of England were to view the reaction of lenders to *high priority* changing conditions as being too slow, then it could force a tightening across the industry by increasing capital requirements for those issuing new mortgages.
*“The growing momentum in the housing market is now, in my view, the brightest light on that (FPC) dashboard” – Sir Jon Cunliffe, Deputy Governor of the Bank of England and Financial Policy Committee*
While the above dynamic may take some time to feed through to financial results for the home builders, once again, in our view it is only a matter of time before it does. This will be prohibitive of top line growth and as a result, we feel that the risk reward ratio available with continued investment in the shares is now slanted firmly toward the downside.
Chart Illustrating Loan to Income Multiple for UK Mortgages
Chart Illustrating the Trend in Loan to Value Ratios on UK Mortgages
The Road toward Opportunity
Despite any feelings of impending doom that this report may invoke, and as referenced earlier, not all housing market-focused companies are redundant from the realm of opportunity. While the above reasons are likely to affect the supply side of the mortgage finance market, they are unlikely to do anything that will negate demand for homes.
As a result, and in line with previous trends, we expect the reduction in new approvals to have a positive effect upon demand in the rental market. This, we believe, will drive residential rates higher over the medium term, which is positive for buy to let investors as well as landlords and lettings agencies given that fee income earned through the administration of tenancies is likely to increase under such a scenario.
Consequently, while we revise downwards our price targets for many of the home builders, we maintain our positive bias towards those with a significant exposure to lettings. Countrywide Plc is one such company, which we have been covering since shortly after its 2013 IPO. Foxtons Group Plc is another which we are initiating coverage of. Both of these companies enjoy a significant share of the UK lettings market, which complements their estate agency businesses.
Bovis Homes Group Plc (BVS.L)
February saw Bovis Homes announce a 48% jump in pre-tax profits when unveiling 2013 results, following a year of rapid growth in sales volumes and mortgage approvals. Earnings per share for the period also increased by a similar measure from 30.2 pence to 44.9 pence, while forward reservations for projects that remain under construction reached record levels.
Positive momentum in home sales prices also helped to boost earnings as demand generated by the government’s Help to Buy scheme exacerbated the existing supply and demand disparity in UK housing.
The results follow a year of substantial appreciation in Bovis Homes’s share price, which gained 62.5% from January 2013 lows of 582.00 pence to March 2014 highs above the 925.00 pence level.
Taking into account a recent pullback in the shares, Bovis currently trades on a multiple of 17.19 X 2013 earnings, which is high when compared with other capital-intensive businesses such as Basic Materials, Oil and Gas, Utilities and the FTSE 350 average of 14.73 X 2013 earnings. The valuation is also high relative to other more liquid and cash generative businesses within the consumer goods and services sectors.
Further from here, 46% of full year 2013 sales were attributable to the Help to Buy programme which is currently in danger of being scaled back, given the level of criticism it has attracted in some segments of government.
In addition to this, many of the individuals who have purchased properties through the Help to Buy programme are likely to be those that are unable to save sufficient levels of money in order for them to build a suitable mortgage deposit. This indicates that disposable incomes within this demographic are likely to be quite low and inflexible. If this is the case then tolerance to interest rate fluctuations is likely to be limited.
As a result, it seems fair to assume that a disproportional number of Help to Buy customers will find the new affordability and interest rate stress test regime prohibitive of their ability to secure mortgage finance. This is negative for the future prospects of those home builders that drew a large portion of 2013 revenues from the programme, particularly given the levels of future growth which have already been priced into many of the shares.
In this respect, Bovis Homes Plc is no exception. We expect the new interest rate stress tests and affordability criteria to have a negative impact upon the number of successful mortgage applications, which implies a similar reduction in Help to Buy purchases.
As a result, our belief is that earnings at Bovis Home Plc will fall over the course of 2014, which leaves the present valuation difficult to justify and the shares prone to further weakness.
In relation to trading, we see the shares weakening further throughout the weeks and months ahead with any correction to the upside capped at 800.00 pence, while our medium term price target sees the group trading lower towards the 670.00 pence level before the close of the current reporting year.
Barratt Developments Plc (BDEV.L)
In a similar fashion to Bovis Homes, Barratt Developments also made substantial progress during 2013 and the opening stages of the current year, after putting in a solid performance across all metrics. Pre-tax profits jumped from £45.9 million to £120.4 million compared with the same period for 2014, while forward reservations also increased by 65%.
The steady flow of positive news from Barratt’s management team has driven a persistent appreciation in the shares which have outperformed the FTSE 100 and all of their nearest competitors by a significant margin over the last 18 months.
Barratt Developments (Green), Berkeley Group (Blue), Bovis Homes (Red) and the FTSE 100 (Black)
Despite the positive flow of news and a stellar performance from the shares, we do not believe that BDEV will be immune from the impact of a slowdown in mortgage lending. This is given that 50% of growth in new reservations over the most recent reporting period has been attributable to the government’s Help to Buy programme, while 70% of all sales can be attributed to some form of assistance mechanism.
As a result, our view when taking the external environment into account is that Barratt will face significant challenges in delivering the growth which is currently priced into its shares. Currently trading on a multiple of 25.34 X 2013 earnings, they are far from cheap and in our opinion, this valuation does not accurately reflect the risks attached to home builder shares at present, or the future growth prospects of the industry.
For these reasons we assign a negative outlook to BDEV shares. Our current estimates see any corrective moves to the upside capped at 396.00, for shares currently trading at 374.00 pence as of the time of writing. This is while our medium term price target, at 325.00 pence per share, implies a downward leg of just under 13% over the months ahead.
Barratt Developments Plc
Berkeley Group Holdings Plc (BKGH.L)
Like many of the house builders, Berkeley Group Holdings Plc (BKGH) has enjoyed a run of stellar performance from both an operational perspective as well as in relation to share price returns over the last 18 months.
While the group is yet to release full year results to cover the May 2013 – April 2014 year, first half numbers released late in 2013 did indicate that the group had gotten off to a good start. However, the shares have recently sold off, in line with the wider house building sector, out of fears that rising rates could slow the uptake of new mortgages and concerns that the government’s Help to Buy programme will be scaled back just after its extension through 2020 has been announced.
In addition to this, with almost an exclusive focus upon London, sentiment toward the shares has worsened due to uncertainties surrounding tax laws, high value properties and foreign investors. Despite this, there are positives for Berkeley group and although our tone toward the home builder sector as a whole is resolutely bearish at present, BKGH is an exception.
Our central view is that even with recent changes to tax laws and an uncertain environment for overseas investors, it is more likely than not that London property will remain a safe haven for foreign nationals who are seeking a safe stable in which they can park funds for the medium to longer term.
In addition to this, we also view the new tax changes surrounding high value properties as likely to form a positive driver of demand in the lower to middle segments of the London market, as many of the tax changes only affect, to any significant degree, properties over the value of £500,000.
These dynamics we expect to support Berkeley Group, even as the downturn in mortgage lending progresses. At the company level, the group has recently reduced its debt pile to nil, while it also has a strong pipeline of projects in prime London locations and an attractive capital return programme in place for shareholders.
The capital return programme has seen the group commit to dividend payments which total 270.00 pence before September 2015, which equates to a yield of 8.5% based upon today’s share price. From a valuation perspective, the group currently trades on a multiple 16.37 X 2013 earnings which compares well against its other industry counterparts, particularly when the group’s exposure to the London market is taken into account.
In short, we like Berkeley Group Holdings Plc over the medium to longer term. The group is set to announce full year results for the 2013 – 2014 year on 18 June, which if past performance is held constant, could drive a recovery in the share price over the near term.
Despite this, the group will remain sensitive to general investor sentiment toward the home builders and as a result, if the wider sector weakens further then there is always the chance that Berkeley Group could fall in tandem. However, we believe that time will see the group standing apart from the crowd when compared with many of its industry counterparts.
In terms of price targets, we do not presently envisage any downside in the shares leading to a break below the 2000.00 pence level throughout the months ahead. This is while on a medium to longer term basis we expect the group to continue to benefit from elevated property prices in the London and strong demand for from both local and international buyers with sufficient wealth and income to weather the new affordability regime in the mortgage market.
As a result, we do not view a return to previous highs in the region of 2,800.00 as outside the realms of opportunity; however, we feel the shares are more likely to stabilise slightly below here, at or around, the 2,637.00 pence level.
Berkeley Group Holdings Plc
Countrywide Plc (CWD.L)
In line with expectations, the positive performance of 2013 has continued into the current period for Countrywide, with strong growth across all segments of the group. The May interim management statement saw the group announce that income rose by 35% on a year on year basis during the opening stages of 2014, with notable contributions from residential lettings and mortgages.
This was while the group also took steps forward at the operational level with continued efforts to capture more residential listings, both nationally and internationally.
“The strong momentum evident in the later stages of 2013 continued into Q1 2014 with very strong growth in revenues and profits achieved across all parts of the Group.” – Interim management statement, 09 May 2014
Despite this, Countrywide remains a quality play on the supply and demand disparity in UK housing; one that in our view is well hedged against the cyclical nature of the market. This is given its significant exposure to residential lettings and London property, which at present accounts for 60% of the group’s underlying earnings.
On a slightly less positive note, management did sound the horn of caution earlier during the month by referencing competition for listings in the estate agency arena, stating that this could put pressure upon fees and overall performance in the division.
We hold a positive view of both the London property market as well as the residential lettings arena, and believe that CWD’s extensive focus in these areas provide it with an attractive differentiation from many of the companies covered previously in this report. With the group lacking the capital intensity of the home builders and avoiding the financial credit risk of the banks; we reiterate our view that it is well hedged against a slowdown in mortgage lending.
In relation to the shares, Q2 2014 has seen them retrace from previous highs in the 700.00 pence region to the current level of 540.25 pence. Now that the property sector seems to be undergoing a unanimous correction, it is possible that the shares will decline further over the months ahead, in line with the wider market, given that no new performance information of any significance is due to be released until October.
In terms of price targets and trading expectations, we see strong support for the shares at the 500.00 pence level and do not envisage a break below here over the near term. This while our previous price target of 735.00 pence remains in place and unchanged.
Countrywide Plc 8 Hourly Chart
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