Value Investing & Housebuilders, Part 1: Industry Statistics and the Government

his month has certainly been the most unproductive in the short history of this blog. My stock of ideas has kept growing but my willingness to actually act on these ideas has continued to shrink. I have continued to cut back on risk with the latest big changes in the VH portfolio being my disposal of all my retail stocks (Marks & Spencer (LON:MKS), Debenhams (LON:DEB), and JD) apart from a small position in Greggs and my acquisition of a massive short ETF position which should hedge around 50% of my ‘market risk’. I wouldn’t say that I have turned more bearish but it seems clear to me that although a 10% earnings yields is nice enough the risks involved are just too great.

As a result, I have begun to turn my mind to those sectors that haven’t really recovered since 2008. One of my first ideas was banks which seem to be the favourite value stock of choice amongst those investors of skill and reputation. I took a brief look at BAC’s 400-odd page 10Q and, unsurprisingly, concluded that I really didn’t know what I was doing. The other two perennial value sectors are pub stocks and house builders stocks. One of these areas has been done to death here so we will turn to the other.

I will split this topic up into two posts. In the first, I am going to give a general overview of the industry and the sort of  numbers involved. I am also going to look at the house building programs announced by the government recently and try to find out how important this is going to be for the industry. In the second post, I am going to attempt to value a house building company, Barratt Dev. and look at some of the potential problems/challenges involved in actually valuing these companies.

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Summary:

• Both housing starts and completions have fallen dramatically in the past few years. Housing starts tend to lead to completions by roughly two years. Housing starts bottomed in the first quarter of 2009 and completions have stopped declining in recent quarters.
• However, at current levels it seems there is a significant shortage in new housing. If we are to believe the government’s 2008 projections then current starts need to grow slightly more than 140% to meet projected demand (not including the shortage that will have built up since the original projection).
• Investors should be interested in this situation as the current supply/demand situation will have to corrected in the near future. However, the UK government has begun to take a serious interest in trying to close this gap itself.
• Housing is a politically contentious topic. For investors, this means uncertainty as governments will not hesitate to push hard for a correction in the current housing market. It seems unlikely that the indemnity scheme is going to be the last intervention and it seems equally unlikely that we can accurately predict now how far the government will go (esp. as some housing policies already announced seem ideologically uncharacteristic).
• The terms of the Indemnity Scheme are clearly weighted against house builders. 100,000 houses would make a big difference to the supply and demand situation of the market however, it isn’t clear why house builders would contribute as the scheme exposes them to quite significant risks especially given the fairly weak financial position of the sector already.
• The Affordable Housing Scheme promises a lower ASP for participating builders and, if the program is effective, should bring a significant amount of supply onto the market. The outcome of this is generally more clear than the Indemnity Scheme but there are still questions.
• In short, one way or another, the government probably is going to have some effect on the supply/demand dynamics of the industry. However, the dynamics of the industry haven’t changed. Most importantly, the terms of the Indemnity Scheme seem to suggest that banks are still causing significant problems in the industry and that an essential bottleneck is an improvement in their financial position. This is especially worrying with interest rates as low as they are.

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Fortunately, housing seems to be a ‘serious’ topic for government so we have some good statistics about the size of the market and what has been happening over the past few years.

All three tables chart the housing starts and completions for England over three slightly different periods. The first is annual, the second is quarterly, and the third is 12 month rolling figures taken from the quarterly data (i.e the last four quarters). The data is split up into three sources: private enterprise, housing associations, and local authorities. It is worth pointing out here that during the mid-2000s housing associations were around 12% of starts (a similar amount of completions) but the recent drop in starts has been led by private enterprise so in 2010 the same ratio was 22% (If any readers are interested in the fine grain data, go to the statistics section at www.communities.gov.uk).

There are a few idiosyncrasies in the data the most important of which is the difference between the ‘housing’ year in the data and the calendar year. The housing year goes from Q2 to Q2 which is the basis of construction for both the annual data and the quarterly data which starts in Q2/08.

 

The last data point we have is the quarterly data point for Q3/11 which ends in September. The basic picture here is, unsurprisingly, a significant slowdown in starts through 2008 with a bottom in Q1/09. Unfortunately, we don’t have quarterly data going further back but from the annual data we can infer that the peak in completions lagged that in starts by roughly two years. As starts bottomed in Q1/09 we might expect to see completions picking up again fairly soon. At the moment, all we can say is that completions have stopped falling.

Given this picture of supply we need to start filling out what is happening with demand which means turning to the data on the actual stock of houses. In March ’10, there were roughly 22.7m dwellings in England (We should get the data for March ’11 at the end of this month). We can get another useful number here if we divide Completions by Stock which should give us a measure of liquidation. So 106,000/22,700,000 is 0.47% which emphasizes the slow turnover in new house demand.

However, the government has also given us an estimate of the required housing stock for 2033 (this projection was made in 2008). The forecast required stock in 2033 is for 27.5m houses an average growth over the period of 232k houses per year (for anyone interested, the fastest growth is projected for the South-East). Now with 12m rolling starts at 96k (starts typically lead completions) we can see that demand is massively outstripping prospective supply, with projected demand being 140% greater than current starts. So although the housebuilding sector is clearly a troubled industry we also should recognize that there is something interesting going on however, investors aren’t the only ones to notice this.

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In almost every sector I have looked at in the past year or so the government has either actively intervened or is planning too (dairy, pubs, and cars) and given the emotional valency of housing it isn’t surprising that the government appears to be planning another major intervention. Again, the website for anyone interested is the Communities and Local Government Department.

There are four main items which are the most effective in explaining the government’s approach: the first release announcing a new policy, the second release which is essentially fills out the detail (it names the participating housebuilders), the reaction of housebuilders (as this is on the government website we shouldn’t expect the full “truth”) and a policy document outlining general housing strategy.

Before we get into the detail I think I should mention my general opinion on government intervention. Although I do not have a set opinion on how important the government are going to be I am reminded of my research into the pub industry. What I take from this is that certain issues really agitate politicians to make serious intervention and housing is probably the ultimate issue of agitation. To me, this suggests two things: first, this probably won’t be the last bit of ‘strategy’ we will hear of and second, if housing starts continue to stagnate the government will be prepared to go further than I imagine or expect today. Indeed, I am already quite surprised by some of the government’s ideas, particularly the support for 30-year fixed mortgages which have never seemed a particularly natural financial invention. However, this probably emphasizes this idea that housing is really the ‘hot topic’ for politicians.

So the core of the latest move is the indemnity scheme which, to put it simply, provides a guarantee for up to 100,000 new mortgages at up to 95% LTV on new build properties. From what I can tell the core response for this scheme has been negative with much of the opprobrium focused on the LTV portion. As I am not an expert, I will reserve full judgment but given how the housing market fell apart this seems like a somewhat risky way to put it back together. However, from the perspective of house builders something concerns me slightly more. In the second release, which outlines the detail of the scheme, we learn that for each property sold the house builder will contribute 3.5% into the indemnity fund with the government supporting the other 5.5% (it took me a while to work out the government’s stake as the release is highly ambiguous). If a house purchased under the scheme is repossessed the indemnity scheme will make up any shortfall from the value of the property with the house builders taking the first loss. Finally, the second release all highlights that some co-ordination will be required between lender and house builder.

To fill this out with a (very hypothetical) example, BDEV had a roughly 10% share of total completions so lets say it builds 10,000 houses under this scheme. The boost appears to be aimed at somewhat affordable housing so lets say the average price is £150k. Revenues of £1.5bn, gross margins of 11% and profit of £165m. However, for each property it also has a potential liability, if house prices fall by 5% and we have another recession (they would presumably coincide more often than not), of £52.5m. I am not too sure how to quantify this risk. One idea is to weight the outcomes by probability so if there is a 25% of a downturn the value of this profit is £110m and if  the probability is 50% then the weighted value is £56m. Either way, the basic fact is banks doing more risky lending at a higher LTV with all the vast majority of risk being borne by the house builders. What is more surprising is the size of the government contribution which is really quite paltry and will only be paid after house builders. It is true that some builders such as BDEV already have some exposure to these risks as it has some second lien mortgages with a book value of £170m on its books. Regardless, I can’t see why any house builder would, willingly, take part in this scheme. So 100,000 houses is a significant number but the terms of this deal are quite heavily skewed against house builders.

The other side of government housing policy is the Affordable Housing Program, which is a grant program to encourage house builders to develop affordable housing. Unfortunately, every press release has slightly different figures about how many houses and actually going to be built and at what cost. My understanding is that the government is looking for 170,000 by 2015 and it appears 80,000 contracts have actually been arranged. However, the costs on this are unbelievably vague with numbers from £4.5bn over the whole program to £1b. As a result, I am not sure how good these deals are for house builders but the grant appears to be around £5-10k per house built. The most important point though is that some house builders (such as BDEV) are not participating and given the numbers of starts currently we can expect the program to have quite a significant effect on housing supply.

These programs have the potential to dramatically change the supply/demand dynamics of the industry however, due to various uncertainties inherent in their construction we cannot begin to predict the outcome. The terms of the indemnity scheme seem skewed against house builders so although 100,000 houses is significant and although banks will be very keen to get involved, it is very hard to predict what how this scheme will actually be used. It is slightly easier to understand the effect of the Affordable Housing Program. Certainly, for participating builders we will see a lower average sales price, regardless of the grant. Builders who don’t participate will feel the effect of the extra supply. However, again we must recognize that the numbers really are not clear yet. Although 80,000 contracts have been arranged and although the program opened in March it appears that not many houses have actually been built.