Yields of 5% plus: but are builders as safe as houses for income investors?

Yields of 5% plus: but are builders as safe as houses for income investors?

The housebuilder sector has been on a hot streak since the end of the financial crisis, with the prices of some shares (see table below) rising by up to sevenfold since the start of 2010. This period has been something of a sweet spot for the sector, as it has benefited rock-bottom interest rates, very cheap mortgages and a chronic housing shortage, among other factors.

Favourable government policies put in place to help property buyers, particularly those designed to help first-time purchasers get a foot on the ladder, have also helped boost housebuilders’ profits, and as a result share prices have soared.

There was one minor blip that halted the impressive winning streak – last June’s vote to leave the European Union. Amid fears of a house price correction on the back of a fall-off in European demand and wider economic slowdown, particularly in London and the South East, investors rushed to hit the sell button, sending some share prices in the sector 30 per cent into the red minutes after the stock market opening bell was struck on 24 June.

MISPLACED BREXIT FEARS

These concerns, however, were misplaced: almost a year on from the EU referendum vote, house prices are holding up better than many economists predicted. As a result most housebuilder share prices have recovered to pre-referendum levels; but investors who did not buy the big post-vote dip last year may not necessarily have missed the boat. From an income perspective, the sector still looks attractive today, with some shares offering juicy dividend yields in the 5-6 per cent range.

These yields look impressive on paper, due to the fact that housebuilders have effectively turned into dividend cash machines – and this trend is expected to continue. Two of the biggest players in the sector, Persimmon and Berkeley Group, have already set in stone the amount they will be returning to shareholders, through either dividends or share buybacks, over the next four years.

According to Brian Cullen, a fund manager at SW Mitchell Capital, housebuilder management teams have become more conservative, as they remember all too well the horrors of the last downturn. During the financial crisis housebuilders paid the price for taking on too much debt.

‘They are now focusing less on growth, and more on sustainable returns and high cash payouts to shareholders. This is why, despite such a strong run, yields are as high as they are today,’ says Cullen, who manages the SWMC UK fund. As well as becoming more disciplined, housebuilders have become more income-friendly on the back of subdued land prices boosting their margins.

‘Land markets have changed the dynamics,’ he adds. ‘From 1991 to 2006 house prices increased by 200 per cent and land prices were up by 400 per cent. Over the past five years house prices are up well over 20 per cent, while in contrast, land prices have not moved at all.’ The benign backdrop is a big boost for the sector. As a rough rule of thumb, the cost of acquiring land usually accounts for 20 per cent of a company’s total costs in building a home.

Another positive factor at play is the demand and supply imbalance. On the supply side, the number of medium- and small-sized housebuilders has been in decline since the financial crisis. Smaller players have struggled to cope with greater levels of complexity when it comes to planning, and bank financing has been harder to come by, while local authorities have tended to favour big firms in the belief they will get schemes built faster. In turn this has reduced competition and played into the hands of the large housebuilders.

LAND SUPPLY GLUT

All this is against a backdrop of an ‘embarrassing amount of land out there [in the hands of housebuilders]’, points out Craig Yeaman, manager of the TB Saracen UK Alpha fund, who holds Persimmon, Berkeley Group and MJ Gleeson in his portfolio. ‘From a dividend perspective, it has been good to see some of the savings made enter the pockets of shareholders,’ he adds.

But in handing out bigger dividend cheques than they have done in the past, housebuilder management teams have sacrificed all-out growth, despite a backdrop of chronic housing undersupply. A cynic might suggest that housebuilders are looking after their own interests by maintaining the supply shortage and as a result keeping house prices elevated.

This approach has failed to impress some investors, including Mark Slater, manager of the Slater Income fund. Slater is favouring the housebuilders that are not sitting on their hands and are ‘increasing volumes [of housing units]’. He adds that too many firms in the sector are ‘not looking to grow and are instead retaining capital’. He owns Bellway, Taylor Wimpey, Galliford Try and Aim-listed Telford Homes.

The chronic shortage of housing is a long-term structural driver that will continue to benefit the housebuilding sector, points out Sanjiv Tumkur, head of equities research at Rathbones. ‘The government recognises this shortage and is consequently supporting the housebuilding industry with a target to deliver one million net additions to the housing stock by 2020. Support measures include speeding up local authority planning, releasing publicly held land for development, and the Help to Buy scheme for first-time buyers.’

He adds that while a high proportion of the cash flow currently generated by the sector is being distributed as dividends, it is worth keeping an eye on just how those dividends are being paid. One trend is a tendency to lavish shareholders with special dividends – but investors should bear in mind these payments usually only occur during the good times.

In addition, it is worth remembering that during the last downturn, even regular dividends were cut or cancelled. Due to its cyclical nature, the housebuilding sector’s future fortunes hinge on the UK economy remaining healthy.

Some investors, including Mark Martin, manager of the Neptune UK Mid Cap fund, are nervous over how the Brexit negotiations will pan out. In the event of a ‘hard Brexit’, consumer confidence will take a knock, and that could cause housing demand to cool. ‘The tailwinds that have given the sector a big helping hand are now starting to fade,’ adds Martin. ‘Help to Buy will end in a couple of years, while quantitative easing, which has pushed mortgage rates down, is unlikely to remain in place indefinitely.’

Chris White, manager of the Premier Income fund, is currently ‘reviewing’ the credentials of the sector. White bought Bellway and Crest Nicholson last summer, following their share price dips, but he is now reconsidering his position amid growing concerns that an economic slowdown will materialise in the second half of the year. ‘The real issue is how the economy will hold up both during the negotiations and post-Brexit. The various indicators I look at suggest households will slow their spending, so I think anyone looking to enter the sector needs to be careful.’

Against that, a notable name who has just bought into the sector is fund manager Neil Woodford, with shares in Taylor Wimpey and Barratt Developments. The two shares hold top- 10 positions in his recently launched Woodford Income Focus fund. He has also bought positions in Crest Nicholson and Bovis Homes.

In entering the sector, Woodford makes it clear he is not of the opinion that valuations have become too pricy on the back of the sector’s strong run over the past seven years. The manager, who has made various successful sector calls over the years, is banking on his market outlook being correct.

‘In the run-up to the fund launch, I said I believed there was an attractive domestic opportunity, in part because people were too downbeat about the UK economy. The bearish mood has resulted in big share price falls in some domestic cyclical sectors, and it is this opportunity set that I see in the stock market. I have been taking advantage of some depressed valuations in domestic cyclicals, selectively buying stocks in sectors such as housebuilders, banks, construction, building materials and property for the new fund,’ says Woodford.

While a downturn does not look imminent, there is a sense that the sector has enjoyed its best days from a share price return standpoint. But from an income perspective it has become more appealing and is arguably a safer bet than similarly yielding cyclical sectors, notably banks and miners. However, the big call for investors to get right is whether the economy will remain resilient enough to keep the housebuilding sector on a steady footing.

FUND AND TRUST CHOICES TO PLAY THE PROPERTY MARKET

Investors wanting exposure to the property sector but who don’t like the idea of investing in housebuilders directly can outsource the decision-making to a fund.

Broadly speaking, there are two types. The more common are funds that hold physical property. Investors taking this route should look to investment trusts, as at times of stress open-ended funds bar investors from exiting, a scenario that played out last summer following the Brexit vote. Investment trust shares may take a hit as investors get out, but the managers do not have to sell the portfolio itself.

In this space, Money Observer Rated Funds F&C Commercial Property and Picton Property Income are our two favoured plays.

Property securities funds invest in the shares of listed property companies. They are far more liquid but more exposed to the ups and downs of the stock market. Our Rated Fund choice is TR Property investment trust. Most of its holdings are in Europe including the UK.

Share returns and dividend yields
ShareShare price return since start of 2010 (%)Dividend yield (%)Dividend cover (x)
Barratt Developments5876.61.4
Persimmon4965.51.6
Taylor Wimpey4876.91.4
Telford Homes3443.82.3
Galliford Try3287.51.7
Berkeley Group3146.02.1
Crest Nicholson Holdings1365.61.9
Bovis Homes1344.91.7
MJ Gleeson713.12.3

 

Note: Both dividend yield and dividend cover are forward-looking, based on analysts' expectations for the next 12 months.

Source: SharePad as at 24 May 2017.


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