Is it time to buy back into the listed housebuilders?

Cautious optimism may be warranted in regards to UK housebuilders following recent positive indicators in the construction sector. New construction is up on increased demand, house prices are rising and mortgage approvals have increased. On the surface, this is all good news. Below the surface, pitfalls still exist which may make it difficult to sustain growth going forward.

Stock Prices

Stock prices of the major housebuilders have shown some strength since the beginning of 2009, with shares of Redrow, Bovis Homes Group, Bellway and Persimmon up 40% or more. Barratt Developments Plc and Taylor Wimpey Plc , the two most prolific builders, have seen their stock prices nearly quadruple since January 2009.

At this point, analysts generally believe most housebuilders are fairly priced or even still slightly undervalued, with share prices already discounting any potential worst-case scenario.

Construction Starts

After the credit crunch began in 2007, the construction economy put on the brakes too. With demand weak, builders concentrated on finishing their nearly completed stock, but have been wary of opening new sites.

In 2009, new construction has increased again, but this is due in large part to depletion of finished and partly-completed stock. Output had fallen so drastically by the end of 2008 that the recent increases still leave the sector well below pre-recession levels.

House Prices and Demand

House prices have trended upward since March, and housebuilders have seen increased interest. This should be good news, but it remains to be seen if there is any substance to the apparent increased demand.

Mortgage Lending

Mortgage lending remains a sticking point in any anticipated recovery. Banks have been shrinking their balance sheets and lending less. Even banks with solid balance sheets are remaining cautious as long as the economy is in a slump. Overseas lenders have mostly abandoned the UK market until conditions improve.

Lending volume has grown steadily in 2009, but the base at the beginning of the year was so low that mortgage approvals are still well below the "natural churn rate" - sales made due to "natural" events such as marriages, births, deaths and children moving out.

Mortgage lending restrictions prevent most people from qualifying for a loan. Loan-to-value ratios average about 75%, and many prospective housebuyers cannot afford the deposit. Banks are leery of increasing the LTV, for fear of the home loans market once again spiraling out of control.

Prior to the credit crunch, LTVs averaged 90%, and loan-to-income ratios were as high as six times salary. This is comparable to what was occurring in the US mortgage market; nearly everyone qualified for a mortgage with no money down and little in the way of credit checks or proven salary history. US financial institutions have gone belly-up as a result of that mess. UK financial institutions are taking a prudent approach for the time being.

Unfortunately, until the mortgage market opens up, the housing market cannot fully recover.

Mortgage Help

One government program, called HomeBuy Direct, is helping buyers with their deposit. Under this program, the Treasury co-funds deposits with the builder. Buyers must pay back the money later. This is helping first-time buyers, who would otherwise have little chance of affording a new home. It also helps the builders, who are able to move properties that otherwise may not sell.

The downside is that the program is limited to 18,000 properties and the builders will have several million pounds tied up in deposits, and thus unavailable to fund future growth.

Future Growth

While all of this good news is reason for optimism, it is wise to remember that the upswings are only in relation to the recent lows. The housebuilding sector has a long way to go before it even returns to 2007 levels.

With most finished stock depleted, and new construction starting up, the next step toward growth is to increase landbanks. Sufficient land will be critical to future construction and growth. With land prices off by about 50% from their peak, now is a good time for companies to lock in value at a steal. Any company with sufficient cash reserves to purchase now will be well positioned for future growth.

Bovis reported a return to profit in August, with the intention to use some of its cash balance to invest in land. Taylor Wimpey and Bellway have also indicated a desire to purchase land in the near future.

Consensus Recommendations

Analysts are hesitating to recommend housebuilding stocks. Although Persimmon was recently a buy, it has fallen to hold. Bovis, Bellway and Taylor Wimpey are all solid holds. Analysts are bearish on Redrow, giving it an overwhelming sell recommendation. Analysts were split on Barratt just a few weeks ago, disagreeing on whether to hold or sell, but have now united in a sell recommendation.

Despite moves in the right direction, the housing market faces continued uncertainty regarding its underlying fundamentals, and prospects for the housebuilding sector are mediocre at best. The recent stock price run-up was probably all they have to give for the foreseeable future, and big profits in housebuilding stocks are unlikely