Why housebuilders are facing a severe crunch

Housebuilders made the same mistakes buy to let landlords did – they bought land thinking prices would never fall. Now the land is worth less, and the banks are on their backs.

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The FTSE 100 had a pretty grim day yesterday, falling more than 100 points, to end at 5,756.

So why all the gloom? Well, it was an unsurprising combination of miserable retail news, and a hammering for property-related stocks, which then sent the banks lower as well.

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It seems that no matter how low these sectors go, there's always a little bit more to lose

First, let's take a look at the retailers. Supermarket giant Sainsbury's (LON:SBRY) slid as first-quarter sales growth came in below City expectations. Meanwhile, Woolworths (LON:WLW) shed its chief executive Trevor Bish-Jones as the company reported that like-for-like sales had fallen 2.2% in the 19 weeks to June 14th.

Why anyone expects anything other than falling sales from Woolworths is a mystery to me. It's described in most newspapers as a "pick'n'mix retailer". That shows the key problem. No one knows what Woolworths is for. It sells music, homeware, computer games, children's clothes but what everyone associates it with is penny chews. Perhaps slashing its product range and becoming a sweetie shop is a step too far. But it needs to find a niche before it has any hope of recovering.

Anyway. The rest of the retail sector fell too as the weak results reminded investors that regardless of how good a shop is, there's only so much spending consumers can do, and they're rapidly running out of money.

Housebuilders were also still under pressure. Persimmon (LON:PSN) which will lose its place in the FTSE 100 later this week - is one of Goldman Sachs' "key selling ideas", which is a somewhat painful position for any company to be in.

But how can housebuilders be running into all this trouble now, after such an incredible house price boom? The answer's pretty simple here's how.

What's the biggest cost in building a house? It's not your staff all those hard-working Poles and other immigrants saw to that during the boom. Certainly raw materials have been soaring in price in recent years. But your biggest cost in building a house isn't your bricks and mortar, or your copper wiring. It's not even your granite worktops or your walk-in fridge freezers.

The really expensive bit of a new house is the land it's built on. As the old saying goes "they aren't making any more of it."

Now if housebuilders want to keep building, they need to keep buying land to keep their land bank topped up. But as the boom continues, that land gets more expensive. So housebuilders are actually suffering from similar problems to amateur landlords. They've been buying increasingly expensive land, in the belief that the boom will continue forever. Some such as Barratt (LON:BDEV) even bought competitors, mainly for their landbanks, at hugely inflated prices.

But now that the boom's over, prices are falling. Housebuilders are going to have to take a long hard look at their balance sheets. A lot of that land just isn't worth as much as it was at this time last year. Some of it might not even be worth what they paid for it. And meanwhile, house sales are drying up, which means they aren't getting as much cash in as they used to.

The problem is that their lenders the UK's banks have lent more than £8bn to the sector aren't likely to be very sympathetic to their plight. That's because the banks need as much money as they can get at the moment too.

UBS reckons that if house prices fall by 20% and house sales fall by a third which is all quite possible then most housebuilders "will make no operating profit next year and break their covenants," says George Hay on Breakingviews.com.

With that level of exposure to the sector, the banks will want to make sure they "extract their pound of flesh". And that would put shareholders in the housebuilding sector in a very weak position.

So it's little wonder their prices have come off so sharply. They could quite easily fall a good bit further.

Especially as we're only a little way into this housing downturn. This morning, HBoS which has stakes in several property groups - has confirmed that its rights issue will go ahead as planned. But it also warned that it now expects house prices to fall by up to 9% next year, a larger fall than it forecast just a couple of months ago. Meanwhile, arrears levels rose from 1.67% at the end of 2007 to 1.89% by the end of May.

So did any stocks actually make gains yesterday? A couple the main risers were in the medical sector. GlaxoSmithKline gained 22p as it won a contract from the Department of Health for its cervical cancer vaccine, and prosthetics group Smith & Nephew was also higher.

The arguments for buying drug groups that you still buy medicine in an economic slowdown, and that the population is getting older are well-rehearsed, but they're still valid. With a dividend yield of around 5%, I still think Glaxo's a worthy addition to any portfolio in this environment.

Turning to the wider markets

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The FTSE 100 index ended down 105 points, or 1.8%, to 5,756. Soaring corn prices sent Tate & Lyle to a four-year low, while retailers took another pounding. Marks & Spencer slid 5% and Next 6%. Woolworths lost a further 5% as well as its chief executive. Airline stocks also nosedived on fears over high fuel costs.

European markets also dropped, with the German Xetra Dax losing 1% to 6,729 and the French CAC 40 shedding 1.4% to 4,619.

US stocks slid back again, with the Dow Jones Industrial Average dropping 131 points - 1.1% - to 12,029. The wider S&P 500 fell 1% to 1,338, while the tech-heavy Nasdaq Composite also eased 1.1% to 2,430.

Overnight the Japanese market followed the US lead, with the Nikkei 225 plunging 2.2%, i.e. 322 points, to close at 14,130, while in Hong Kong, the Hang Seng also suffered with a 2.2% slump to 22,819.

Brent spot was trading this morning at $136, while spot gold was at $893. Silver was trading at $17.32 and Platinum was at $2077.

In the forex markets, sterling was trading against the US dollar at 1.9625 and the euro at 1.2631. The dollar was trading at 0.6438 against the euro and 107.49 against the Japanese yen.

And this morning, there's more evidence that people are turning to public transport as fuel prices rocket. Bus and train operator Go-Ahead Group said it expects to beat last year's record earnings as bus and train traffic rises. The group has also hedged its fuel bill at its bus unit (it is London's biggest bus operator) at an average 43p a litre until June 2009, and a further half of its requirements at an average 52p a litre for the following year, reports Bloomberg.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.