Home to roost

This excellent article by Doug Morrison of Property Week illustrates why supply of homes won’t be able to keep up with demand for many years now.  This is why UK residential property will perform much better than UK commercial property for the forseable future.

By Doug Morrison

In the recession, housebuilders have replaced the boom practices of land banking and high-volume speculative development with a more risk-averse approach

There was a distinct sense of dEJA vu last month when Berkeley Group bought its first big site since the onset of the housing downturn – a prime development prospect in Belgravia.

Berkeley’s redoubtable boss, Tony Pidgley, who famously predicted the early 1990s recession, was sending out the message that London’s prime housing market has reached its low point.

Belgravia was Berkeley’s first site purchase following its share placing in February. This raised £50m on top of cash reserves to give the group more than £300m to take advantage of the slump in land values. The group is thought to be lining up further land purchases.

So far, so very Tony Pidgley. Except that this time, things are not quite the same. Nowadays Berkeley eschews what Pidgley would call ‘plain vanilla’ housing for select London sites or regeneration projects. Even in the weeks since snaffling up the Belgravia site, the man himself has stepped up to the position of chairman after 33 years as managing director, making way for the group’s finance director, Rob Perrins, to take his place.

Times change, and the debate that is starting to rumble in some parts of the City and the industry is over whether Berkeley’s quoted peers are bold enough or clever enough to adapt to the more subdued market conditions outside central London.

In its latest sector report, broker KBC Peel Hunt questions the viability of the established development model for new housing in ‘a stubbornly high-cost and low-inflation environment’.

The firm’s building analyst, Robin Hardy, points out that construction costs have not been well controlled and remain high, and that there is ‘a growing legislative overhead’ as government policy requires more sustainability in the push towards zero-carbon development.

Hardy writes: ‘Land is perhaps the only cost element over which the builder has any material influence and, in theory, land values should adjust to levels dictated by developers.

‘However, with selling prices so low and other costs remaining high, the price of land that would allow builders to make an acceptable return has become “de minimis”. There are likely to be few sellers at these levels, especially when record high prices were being paid less than two years ago.

‘This raises the question of whether the established development model of land banking, the hope of inflation and use of traditional building processes is broken beyond repair. It may well be, and an entirely new, quicker and less capital-intensive process may need to be invented. The industry started down this road 10 years ago, but abandoned it, instead favouring consolidation, which has delivered almost nothing tangible. This “lost decade” may come to haunt the industry.’

Reinventing the deal

Hardy is not alone in thinking the sector needs to reinvent itself. In Property Week this month, EC Harris’s head of residential and commercial development, Mark Farmer, suggested that housebuilders could assume more of a development manager role, especially if the government and the Homes and Communities Agency succeed in their campaign to encourage institutions to invest in residential property.

Farmer believes that housebuilders’ debt levels are the result of a business model based on high-volume speculative development and an appetite for mergers and acquisitions. He says that investors will be looking for a more risk-averse ‘build-to-order’ approach from housebuilders.

The sector is limping along, albeit without the same levels of anxiety it experienced during the ‘lost year’ of 2008, when massive land writedowns pushed Taylor Wimpey and Barratt Developments – the market leaders in output if not profits – to the brink of breaching their banking covenants.

“Even when the market improves, production will be constrained by debt levels and the lack of finance to fund expansion”
David Pretty, Home Builders Federation

Even now both groups are suffering the aftershock of ill-fated, top-of-the market mergers, but Peel Hunt’s Hardy claims that virtually the entire sector is suspect.

He has marked down shares in all the leading housebuilders as a ‘sell’, with the exception of Bovis (hold) and Galliford Try (buy).

A more bullish note from Merrill Lynch this month upgraded its ratings on Persimmon and Taylor Wimpey to ‘buy’, not because of any intrinsic improvement in new-build house sales but because it felt that the City had gone too far in its hammering of housebuilding stocks. The shares are standing at what analyst Mark Hake believes is an unduly harsh discount to net asset value, although he believes that all housebuilders face the prospect of further land writedowns and rights issues over the next year.

As Hake readily concedes, the Merrill Lynch report is very much a short-term ‘valuation call’. Although he believes the wider housing market will recover in terms of transactions and prices, he questions whether the industry can go back to its boom market practice of holding large land banks and strategic sites.

‘It may well be that industry balance sheets won’t be able to support that approach either,’ he says, ‘because companies won’t be able to afford to hold such land banks. Or, conversely, the recovery is so slow that they won’t be allowed by their investor owners to sit with such land banks, and the focus is going to be much more on returns – churning your land stock rather than maximising your operating margins.’

Hake adds: ‘If they don’t become land hoarders, then the NAV argument becomes less relevant in the long term. If that’s the case, people would look at them more as a contractor-manufacturer-type business. You could argue that, if you’re not sitting on lots of land assets going into a slowdown, that’s probably a better position to be in because you don’t have the risk of shock to your balance sheet in terms of writedowns.’

Pretty speaks volumes

However, one of housebuilding’s best-known figures, David Pretty, believes the sector can anticipate ‘a low-volume scenario’ over the next few years. The former Barratt chief executive, who is chairman of the New Homes Marketing Board and a director of the Home Builders Federation, recalls the early-1990s recession when the industry – including housing associations and commercial developers that embraced residential – still built more than 130,000 homes a year. This year’s output is expected to be half that.

‘Most housebuilders will tell you that, even in this market, they could have sold a lot more homes had it not been for the lack of mortgage finance, which is the lowest in memory,’ he says. ‘That’s been an artificial constraint on top of the recession.

‘The whole industry has got substantially reduced productive capacity now. The sector has probably laid off 50% of its staff, and that can’t be turned back on overnight. Even when the market improves, production will be constrained by debt levels and the lack of finance to fund expansion.’

Pretty says he is optimistic about the sector’s prospects. However, he adds: ‘For the foreseeable future, the housebuilders wouldn’t be able to build the numbers they were building in 2007, even if they wanted to.

In any event, there will be much greater focus on repairing their balance sheets and also a concentration on recovering their margins rather than volume itself.’

After the financial scares of the past year, that is one reason to be optimistic. (Doug Morrison, Property Week) http://www.propertyweek.com/story.asp?sectioncode=530&storycode=3145215


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