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.

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 that a 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

Housebuilders - part exchange and shared equity exposure

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.

Company Market value (£m) Tangible book value (£m) P/TBV ROE
Barratt 1,656 2,020 0.82 3.87%
Bellway 1,115 1,090 1.02 5.75%
Bovis 663 732 0.91 4.00%
Persimmon 2,316 1,645 1.41 8.31%
Redrow 547 560 0.98 5.40%
Taylor Wimpey 1,769 1,870 0.95 5.47%

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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  • eddy

    Many of my friends are builders and they are saying the market especially in the north is terrible. They have also all taken huge pay cuts as there is a flood of unused labour onto the markets forcing wages down. Builders are cutting their throats for work.

    Makes me laugh property prices around my parts are now be advertised as reduced for quick sale, really it should say reduced as it was over priced in the first place!

    i hear 60% of property transactions in London are currently to overseas investors…sounds like a bubble to me, once the investors feel the euro zone is safer that money will be brought back causing prices to drop in London, all imo of course :).

  • Zerost

    Call me old-fashioned but shouldn’t builders earn their money by building houses and not by running cartels and speculating on land prices.

    A quick look on Wikipedia on Cartels and it should just read “UK house builders”.

    ” A cartel is a formal agreement among competing firms. It is a formal organization where there is a small number of sellers and usually involve homogeneous products. Cartel members may agree on such matters as price fixing, total industry output, market shares, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits or combination of these. The aim of such collusion (also called the cartel agreement) is to increase individual members’ profits by reducing competition.”

  • Zerost

    Call me old-fashioned but shouldn’t builders earn their money by building houses and not by running cartels and speculating on land prices.

    A quick look on Wikipedia on Cartels and it should just read “UK house builders”.

    ” A cartel is a formal agreement among competing firms. It is a formal organization where there is a small number of sellers and usually involve homogeneous products. Cartel members may agree on such matters as price fixing, total industry output, market shares, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits or combination of these. The aim of such collusion (also called the cartel agreement) is to increase individual members’ profits by reducing competition.”

  • Manabana

    The author assumes house prices will come down, but if the Government has managed to keep them stable thus far, what will have to change to bring about their collapse? Unemployment? plenty of unemployment around but no change, a person can always get benefits or something to help them hold onto their house thanks to low repayments. Interest Rates? I don’t see these going up for another 5-7 years so no impact there. Inflation? people will just cut back on their spending and keep paying the rent and mortgage. Cataclysmic event? The eurozone problems have only helped London house prices as its seen as safe haven for foreign money investing in property.

  • Critic Al Rick

    @ Manabana

    You ask: “What will have to change to bring about their (UK house price) collapse?”

    IMO nothing will have to change; it’s in the pipeline. Pensioners, present and future, are presently being pillaged to feed the Parasites (rich, poor and intermediate) – previously fed by selling-off ‘family silver’ and increasing Gross National Debt.

    As time goes by more and more pensioners will be forced into accepting relatively low offers on their houses as they ‘downsize’ in desperate attempts to make ends meet. There should be a knock-on effect to include all houses.

    This effect, insofar as TPTB are concerned, is known as ‘hoist by their own petard’. Unfortunately, I fear we’ll all probably be ‘hoisted’ along with them.

  • charles.scatchard@ntlworld.com

    Banks are now nervous that House prices could collapse so are bound to be unwilling to lend as before when they could simply take the House and sell at a profit. They want the lender to have a big enough deposit to take care of any future negative equity the may arise. Very sensible really. I agree there is a racket at work here keeping prices high. Its great for those of us with mortgage free Houses but sole destroying for the hard working youngsters. You cant hold back the tide for ever though.

  • Jonathan

    The banks are already starting to raise interest rates. They’re not sitting around waiting for the BOE.

  • Harry

    Re: Interest rates and negative equity-look at the figures on this table: https://www.bankofengland.co.uk/boeapps/iadb/Repo.asp You’ll notice how since 1975 the average is more like 10% rather than the current 0.5%! It’s only since 2008 that it came down from 5% to today’s 0.5%. The table suggests that we’re in a moment of government desperation to get buyers buying in an unprecedented crisis. Interest rates can only go up from now and they’ll have to with inflation so rife. Buy now and you’ll wish you waited…

  • NeutronWarp9

    Give the average wannabe Brit access to cheap money and see them race to run up debt on their little, damp houses and shop for Far Eastern tat they don’t even need.
    ”At least my little damp house is bigger than your little damp house and is in a more ‘desirable’ location”. (In most case 10 minutes walk from council owned property occupied by lesser-types).
    I always thought the money markets priced interest rates based upon risk / reward profiles and the availabilty of competing investment assets, etc. Apparently not. Some believe the BoE can – King Canute-style – refuse to accept the existence of greater forces.
    Inflation will effectively reduce house prices in real terms and the dumb British public will still believe £200,000 is a big number. Using the going rate of the day, Dicken’s Bob Cratchit kept a family of six on 15 shillings a week in 1843 (equiv today to £3,276 per year). Inflation is a nasty beast, but only if you are able or choose to recognise it.

  • Boris MacDonut

    #9 Neutron. Aside from the fact that Cratchit had no tax to pay, no rates, no TV license, no car tax. He had no running water, no heating, no TV, no car etc. You seem to answer your own point. The British public realise that inflation can reduce the value of what they may borrow. In 170 years you show it has reduced £1 to only 1.2% of it’s then value.Likewise the debt. £100k of debt now would by those standards equate to just £50k in about 24 years. At that rate the spare money could address the damp problems.

  • Andy

    #10 Boris MacDonut “The British public realise that inflation can reduce the value of what they may borrow.”

    This is only true when there is wage inflation matching whatever you want to buy with those wages. At the moment even with the lowest BOE rate ever, debts are not being eroded.

  • Harry

    According to Halifax, the average house price to earnings ratio was 4.36 in May 2009. This is down significantly from its peak of 5.84 in July 2007, though still above the long term average of 4.00 In the crash of the early 1990s it dropped below 4.00 in August 1991 and then fell steadily before bottoming out at 3.09 in October 1995. It then took until July 2002 before it returned to 4.00 again — a total of 11 years! It looks like we’ve got a long period of house price decline before those boom years return.

  • Boris MacDonut

    #11 Andy . Of course debts are being eroded. Wages have risen by 12% since 2007. GDP has risen 11%. In 1998 Ibought my first computer for £1700.Now I can buy one 20 times as powerful for £299.It depends what you want to buy.
    #12 Harry.You risk having people ignore your comments if you start them “according to Halifax….”.But if you insist on expecting patterns to appear, then by their discredited information we will be quids in again by 2015.

  • Harry

    @ The ratio hasn’t even bottomed out yet, so by Halifax’s pattern it could be at least another 11 years before prices rise again. That’s about 2023.

  • Boris MacDonut

    #14 Harry. I suppose that may be so, if only the Halifax figures were in any way accurate. But to expect the recesion in HP’s to last from 2007 to 2023 is stretching it a fair bit. You have just extended the lost decade to 16 years.

  • Andy

    #13. Boris MacDonut;
    “#11 Andy . Of course debts are being eroded. Wages have risen by 12% since 2007. GDP has risen 11%.”

    Boris, can I ask where you have got these stats from, some uk government hype ones maybe…? My wages have gone up by about 6% since 2007, while inflation has gone up by way more than that. Unemployment has increased by 1 million at least, and part time work has increased outside of the ‘official’ unemployment figures.

    Debts eroded, dream on!

  • Borassic

    Comparing the demand for diamonds or fast cars to houses is nuts. Those items are not essential, whereas a roof over one’s head is (and the UK’s obsession with home ownership helps the banks in this).

    There is always demand for the essentials in life, that’s why we all poorer thanks to inflation (and that other cartel – the supermarkets).

  • Boris MacDonut

    #16 Andy. The Treasury looks at 40 different forecasting and measuring organistions and takes the average. It had UK GDP at £1,400 billion for 2007 and is at £1,550 for 2012. That is 11%.
    Various places look at pay (I am more concerned with income which is currently £33,000pa) .But pay according to HMRc and the IFS, event he World Bank was at £25,000 in 2007 and is at £28,000 now. That is 12%. Your wages do not dictate averages.

  • Critic Al Rick

    @ 18.

    Boris, you’re playing around with statistics, twisted ones at that. You won’t convince the likes of me that we’ve had real growth (or uncorrupted nominal growth) since 2007, pah!

    And if you discounted the incomes of rich and very rich Parasites, I wonder what the increase in average would then be for the rest; if not a loss in real real terms, eh?

  • Boris MacDonut

    #19 Rick. Please tell us what the real statistics are then. Sorry I only took the weighted average of 40 organisations. Do you have a preferred method for gauging income and GDP?
    “If you discounted… the rich”! What are you talking about? Sounds very dodgy, like holocaust denial. If you ignore the holocaust Hitler wasn’t so bad. That Rick, is playing with staistics, not my recounting of plain facts. The plain fact is UK GDP is £150 billion a year higher now than it was in 2007. We are thus richer and able to buy more.

  • Critic Al Rick

    Boris, you can imply whatever balderdash you like from your plain facts but you’re not going to convince me that the UK is in anything other than BIG economic trouble. You’ve only to look at the record of Balance of Payments Deficits and Budget Deficits to see that.

    But I don’t suppose it bothers you for now if most of the wealth of the Truly Private Sector is put on the sacrificial altar to sustain the pretence that a recovery is taking place and to ensure the further corrupt enrichment of the very rich Parasites. It will.

  • Andy

    Sorry Boris, I have to agree with Critic Al Rick. Those sorts of figures would mean we would not be in the double dip recession that we are enduring, whilst at the same time racking up even more debt! Do I believe government statistics on inflation etc. No.
    I believe that debt will be monetized and inflation will result, but not in house prices in real terms.

  • Tankie Jon

    @ Boris – do you do anything else about from comment here? entertaining as ever though.

    @17 Borastic – a roof over your head might be an essential, but owning your own house is not. There are many ways to get a roof (rent, move in with parents, house share, benefits if it all gets too much) and all of the above reduces demand.

    ‘Want’ does not equal demand unless you have the means to pay for it.

  • Boris MacDonut

    #23 Tankie. At a rough estimate I spend 30 to 45 minutes on here 5 days a week for 48 weeks of the year. With my love of accurate stats I make that 1.8% of my time.

  • Peter

    This article has proven invalid. As a professional I would expect reliable information from you, however… opting to go with instinct instead – a 5.5k investment returned over 25% within 3 months until now mid march, marvellous advice to be dishing out however. I shall look for more reliable sources in the future.

  • Peter


    If the author had done his research he would have found quite clearly that in 28 of the last 33 years, housebuilders had seen a rise of over 10% in the first quater yearly. This is a trend in the market and a valuable opportunity for investors, not a weak market nor a “rally on shaky foundations”.