Argonautica

Professional investors can review published thought leadership and market updates from the Argonaut Investment Team.

‘Do You Have Enough Equity in UK Property?’

Industries and stocks enjoying earnings upgrades are becoming increasingly scarce and hence, we would argue, more valuable. In particular median earnings estimates for the UK homebuilders have, over the last three months, been upgraded by 3%, 8% and 11% respectively for this year and each of the next two years1. These upgrades are being driven primarily by improving margins, due to the dwindling proportion of higher priced pre-2008 land in the sales mix – a fact now well known to the market and baked into consensus numbers. However we would caution any investors thinking that the upgrade story is over. Far from it, there remains a significant other leg to the story.

The fundamental backdrop in the balance of demand and supply for UK homes remains robust. Based on household formation, England requires over 250k new housing completions annually, against a current run-rate of just over 100k completions. This level of building is in stark contrast to that achieved during the 1930’s and 1960’s, where annual completions touched over 350k units annually2. In the 1930’s alone over 2.8 million homes were built3. Indeed it was a decade which saw heavy investment in housing and infrastructure as a way to stimulate growth - sound familiar? It is not surprising then that the government has been unveiling plans to stimulate the housing market, and in particular the newbuilding market. The plans though are aimed primarily at enabling potential buyers to transact, as mortgage availability and the associated high deposit requirements remain the key limiting factors to lifting the low level of housing transactions – currently running at nearly half the level they were five years ago.

The initiatives are numerous and have grown in size, reflecting the government’s clear determination to tackle the issues. In addition to the Funding for Lending Scheme launched in July last year, in March the government unveiled another mega-plan. The new initiative “Help to Buy” (HTB) which began in April (and replaces FirstBuy and NewBuy) is targeting newbuild homes and will see the government providing all buyers (previously first timers only and income capped) with an opportunity to receive a five-year interest free loan from the government for up to 20% of the property value (which can’t exceed £600k). Essentially a buyer would thus only need a 5% deposit and a 75% mortgage2. This is directly aimed at trying to stimulate mortgage availability and alleviate the relatively high deposit requirements currently facing buyers. The table below neatly illustrates how the scheme would work.

Table 1: Example of a home purchase with an equity loan scheme

Source: www.gov.uk

Crucially, the new scheme sees the government putting up the entire 20% equity loan. Previous schemes required the homebuilder to share the loan 50/50, now they don’t - thus freeing up capital to the builders. Overall, this new scheme is not only better in terms of its associated detail, but also in its size. At £3.5bn, it is almost seven times larger than the old scheme (£530m). Translated into volumes, it is estimated that this could support between 75k and 100k units over three years, or 25% to 30% of current annual transactions4.

The other part of the new HTB initiative (to begin in January 2014) is a mortgage guarantee scheme which is aimed at increasing the availability of high loan-to-value mortgages. The scheme enables lenders (banks) to purchase a government guarantee that compensates them for 95% of their losses on up to 20% of the loan (the portion directly below the equity provided by the borrower). Again both the detail and size are better than its predecessor. This guarantee is available for all property types (capped at £600k) and at £12bn, its size dwarfs the £1bn of the old scheme. Translated into volumes, it is estimated that it could support approximately 20% to 25% of annual mortgage approvals4.

Assuming then that, collectively, these new initiatives do indeed stimulate volumes and thus, most surely prices, what affect would this have on the earnings for homebuilders, and how does this compare to current expectations?

In order to get an idea of the effect of a pickup in sales (volume x price) we analysed a universe of six listed homebuilders and compared current median estimates for 2015 to those for the period 1996 to 2007. What it showed is that while analysts expect a continued rise in homebuilder profitability to well above historic median levels (as measured by profit margin), they anticipate little in the way of increasing transactions and volumes, as described by asset turnover (sales ÷ assets).

Table 2: Estimated and historic profit margins and asset turnover

1 Source: Argonaut Capital Partners, May 2013. Universe: Barrattt Developments, Persimmon, Taylor Wimpey, Redrow, Bellway, Bovis.

If we assume though that sales do indeed pickup, through a combination of volumes and prices, and homebuilder asset turnover by 2015 rises to similar levels as its historic (1996 – 2007) median level, the effect on earnings is significant. In fact earnings would be 41% higher than current estimates.

Table 3: Estimated and potential net income for 2015

1 Source: Argonaut Capital Partners, 3 May 2013

Whether these new initiatives work only time will tell, but recent industry comments from both lenders and homebuilders suggest that activity is indeed picking up. Certainly these new initiatives are significantly larger and broader in scope than any previously and show a clear determination by the government to tackle the current low levels of transactions and mortgage approvals. The homebuilders have much to gain.

Greg Bennett
Fund Manager

1 Source: Argonaut Capital Partners, May 2013
2 Source: UBS, March 2013
3 Source: Metroboom, George Trefgarne, March 2012
4 Source: Goldman Sachs, April 2013