Avoid housebuilders - the rally is built on shaky foundations

Britain's housing market is stuck in a rut.

Lots of people want to buy houses but can't afford to. The country's banks no longer want to lend lots more money against houses that on most sensible measures look too expensive.

As a result, private house building activity is at its lowest levels since the early 1950s. Indeed, a couple of years ago, the sector was on its knees and practically bust.

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Given the tough conditions, you'd think that investing in housebuilders during the last year would have been a pretty dumb thing to do.

Yet, the share prices of Britain's major builders have soared. What's going on? Is the housing market really out of the woods?

No. Here's why you shouldn't trust this rally and why you should avoid shares in housebuilders.

The house builder rally can't last

Housebuilders have adapted well to the tough conditions in today's housing market. Many used the last recession to snap up cheap parcels of land, which means that houses sold today on this land are profitable.

They've also built more houses, which are in demand, rather than lots of flats. As we'll see in a moment, they've also controlled the supply of houses coming on to the market. These strategies have helped many move from losses to profits.

But can this continue? We don't think so. Housebuilders are working in a false market that cannot last.

Why do we say this? Markets are all about supply and demand. In the market for houses in the UK, both demand and supply are being manipulated.

Let's start with demand. Don't confuse demand' with want'. Lots of people want diamonds and fast cars. But without the money to buy these they cannot demand them. Effective demand is based on people having the money to buy something at the prevailing price. Without that there is no demand, or the price has to fall until people can demand it.

In order to buy houses, most people have to borrow money. During the last boom, banks were only too willing to lend them that money. Many didn't even insist on people paying them back. As long as they could pay the interest on the loan, that was okay.

But- chastened by the credit crunch and tighter regulations - the banks have sobered up. The number of mortgage approvals in the UK is running at about half the level it was in 2007. And prospective house buyers have to put up more of their own money to get a mortgage. The bottom line is thata huge chunk of effective demand for houses has been taken away.

In most markets, this lack of demand would lead to falling prices. But this is not a normal market. The government cannot afford to bail out the banks if lots of mortgages go bad. So the market is being manipulated.

How the government and housebuilders are propping up the market

Interest rates have been cut to rock bottom levels, but banks are still reluctant to lend. So the government and the housebuilders are now trying to shore up the market.

Housebuilders are now lending money to people to buy their houses. Up to a quarter of new houses are subject to some sort of shared equity arrangement with the builder. By taking a stake in the house, the builder can make a sale it otherwise wouldn't make.

This is great news for housebuilders. Not only does it boost their sales, but they can make the sale without having to slash prices. This means their profits are higher than they otherwise would have been.

But this sort of support cannot last. Interest rates will not stay low forever, while there is a limit to the capacity of housebuilder and government balance sheets to keep underwriting new house sales.

In fact, if you include the use of part-exchange incentives, the increasing use of shared equity means that a significant chunk of house sales and price risk remain on some house builders' balance sheets. Should house prices fall, then these equity values will fall too.

Part exchange and shared equity exposure as% of tangible equity

The supply of houses is being kept deliberately low

While demand is being propped up, the supply of houses is being kept artificially low. Housebuilders openly talk of sacrificing volume for profit. For them it makes perfect business sense - increased supply would lead to lower prices and lower profits.

However, the most important element of housing supply is the secondhand market for houses. Many households are in arrears on their mortgages. In a more normal market, these mortgages would have gone bad and the houses would have been repossessed.

But that's not happening today. The banks are desperate to avoid a flood of repossessed homes hitting the market, fearing what it would do to prices and to their balance sheets.

So the supply of houses for sale remains lower than it should be, and prices higher. Again, higher interest rates in the future mean that the supply of distressed houses cannot be kept off the market forever.

But while secondhand housing supply is kept in check, it's good news for housebuilders it means a major source of competition for their products is reduced. Their selling prices and profits are higher as a result of this.

Yet despite the favourable conditions, housebuilders are not actually doing that well. I say this because their returns are still very poor. Returns on tangible equity invested (in other words what you receive as a shareholder) are in the low single digits with the exception of Persimmon - and even its return is pretty poor. (To read more about Persimmon pick up a copy of this week's MoneyWeek magazine.)

Investors should ask themselves whether they are getting a good deal by paying prices close to - or above - this tangible equity value. Given the low return you would get on your investment, we don't think so.

Moreover, these tangible equity values are highly questionable, and are probably too high. Yes, the builders will tell you that they have got land on their books that will give them profit margins of 20-25%. But that's only if house prices don't fall.

Land prices tend to fall faster than house prices. This is because all the other costs of building a house - such as materials - are relatively predictable. So when valuing a piece of land, a builder will work backwards from the selling price of the house he would expect to build on it.

Given that the other costs are fairly stable, a 10% fall in selling prices could mean that the price of the land needed to make a decent profit, might fall by 20-30%.

And given that land values form the biggest part of housebuilders' equity values, that would be very bad news for share prices. So even although the market is doing them a lot of favours, we would steer clear of housebuilders for now the risks are just too high.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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