Property sector builds on firm foundations

An overlooked and undervalued area can continue to show growth, says Jenne Mannion
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The Independent Online

Housebuilding and property shares should continue to deliver concrete returns amid a recovering economy and booming house prices. Nationwide, Britain's biggest building society, this week raised its forecast of house price inflation this year from 9 per cent to 15 per cent, and companies that build new homes are set to reap the benefits.

Housebuilding and property shares should continue to deliver concrete returns amid a recovering economy and booming house prices. Nationwide, Britain's biggest building society, this week raised its forecast of house price inflation this year from 9 per cent to 15 per cent, and companies that build new homes are set to reap the benefits.

Housebuilding and property shares have performed brilliantly over the past three years amid turbulent stock market conditions in which 11 per cent has been wiped off the value of the FTSE All Share index. In the three years since March 2001, the housebuilding sector within the All Share has gained 63 per cent and the property sector 29 per cent.

Both sectors have been particularly strong over the past year. While the FTSE All Share has made a positive return of 27 per cent over the past 12 months, the housebuilding and property sectors have posted superior returns of 59 per cent and 58 per cent respectively.

In spite of this, housebuilders such as Persimmon and Barratt have traditionally been ignored due to the expectation that the housing market would cool. However, as long as house price inflation holds up, these stocks should continue their upward climb. There is plenty of demand for the services of these companies - the government-sponsored Barker report, released last month, suggests that 70,000 to 120,000 new homes per year are needed to dampen house price inflation.

Stephen Ford, a stockbroker at Brewin Dolphin, said high levels of employment, low interest rates, affordability and low supply provide a good background for this sector and continue to fuel demand. "The doom-mongers tend to focus on the late 1980s and early 1990s housing price crash, but investors should remember this is the first cycle we have gone through whereby the Bank of England, rather than the politicians, has been in charge of monetary policy. This provides a much more stable interest rate outlook than we have had in the past. Provided interest rate rises are small and gradual, as we expect, there is still further upside to be had in this sector," Mr Ford said.

Amid this positive macro outlook, and despite their strong performance, individual housebuilder stocks are remarkably cheaply valued. Because of their sensitivity to interest rate rises, housebuilders have always traded at a discount to the market. The price to earnings ratio (PER) valuation measure shows the sector is trading on an average of 10 times, with many stocks having PERs of around six to seven times, compared with 17 times for the All Share.

Adrian Frost, manager of the Artemis Income fund, is not so positive on housebuilders and holds zero exposure to this sector within his portfolio. While he does not expect UK house prices to collapse, he said the strong performance of the stocks ignores the fact that housebuilders must purchase new land, which is in finite supply, in order to initiate a development. "You also have to be suspicious of stocks that have done well due to inflation trends. In this case, the growth has been about house price inflation," he said.

Trevor Green, manager of the Allianz Dresdner UK Growth fund, is similarly negative on house builders. "I believe this is as good as it gets. The BOE has made it clear it wants to cool house prices, but it has not achieved that so further interest rate rises are inevitable, which will affect these stocks. There has also been a lot of talk about consolidation in the sector, but that has not amounted to much," he said.

Nevertheless, the City is turning more positive on these stocks. Numis Securities has issued a review, anticipating that the outlook for UK housebuilders is rosy despite interest rate increases. Preferred stocks include Taylor Woodrow, George Wimpey, Bellway, Ben Bailey and Country & Metropolitan. UBS has also this week placed a buy note on Bovis Homes, Redrow, McCarthy & Stone, George Wimpey and Barratt.

Property companies, like Brixton and Land Securities, are affected by different factors from the housebuilders, and are categorised into the three subsectors of offices, industrial and retail. Offices, in particular, are sensitive to the health of the economy: a robust economy means higher demand for offices and retailers

And, as Alex Ross, manager of the Aberdeen Property Share portfolio explains, there are also highly defensive property shares, such as those involved in lower-cost, out-of-town retail shopping centres.

Irrespective of the economic cycle, the UK-listed real estate sector has been shrinking in recent years. The tax structure of quoted property companies (where both the investor and the company pay tax on income and capital gains) has resulted in property shares trading at high discounts (currently 10 per cent) to their net asset value (NAV).

A boost for this sector was Gordon Brown's Budget announcement that Property Investment Funds (Pifs) can be launched next year, giving big tax breaks to investors in real estate companies. The Government hopes the tax-friendly structure of these funds will encourage investment in the housebuilding sector.

Mr Ross said Pifs could lead to significant further capital flowing into the sector and possibly result in increased yields from the quoted companies. He said: "A number of quoted property stocks in those overseas markets that have adopted such tax structures now trade more closely to their underlying property value, with an enhanced dividend yield."

Mr Ford said the introduction of Pifs should stimulate demand, but believes some of the benefits that are expected to arise are already priced in.

Investors who like the idea of investing in commercial property can do so through UK unit trusts funds such as New Star Property or Norwich Property, which hold about 80 per cent of their portfolios in physical commercial property. Because these funds hold physical property, they are not available as an Isa. Aberdeen Property Share fund is an actively managed portfolio of property based-shares and is available as an Isa.

Close Property runs a portfolio of specialist funds including the Freehold Income Trust, which invests in the freeholds of residential flats, and the Capital Appreciation Trust, which invests in retirement homes. Close also offers a Healthcare and Leisure Property Fund and High Income Properties, which invests in light industrial properties. Finally, there is Active Commercial Estates, a fund which buys properties where it can enhance value within three to five years through refurbishment, renegotiating leases and rent reviews. Investors can also opt for an umbrella fund, Close Property Investment Portfolio.

THE ANALYSTS' VIEW

Brewin Dolphin, the London-based stock broker, has several housebuilding stocks on its buy list, reflecting its positive view on the sector.

Stephen Ford says Barratt has a well-covered dividend, borrowings of just 18 per cent, and a land bank of just over three years. And moves are afoot to cut the red tape involved in gaining planning permission. If the approval process were speeded up, Barratt could reduce its land banks, freeing up a large amount of capital.

Another on Brewin Dolphin's buy list is Taylor Woodrow. Following the acquisitions of Bryant Group in 2001 and Wilson Connolly in 2003, Taylor Woodrow now has operations which extend from the UK to California, Florida and Spain. "Final results (to the end of 2003) were excellent. Operating profits were up by 31 per cent and the dividend was increased by 20 per cent," Mr Ford said.

Wilson Bowden also has a good land bank, financial strength and respected management. A new division focuses on urban flats (rather than its traditional four or five-bedroom semi-detached houses), which should deliver higher margins of 18-20 per cent, Mr Ford said.

Alex Ross, manager of the Aberdeen Property Share fund, holds a large exposure to Capital & Regional. He describes this as a well-managed company that runs four funds that invest in out-of-town retail sites and has demonstrated strong growth for the past eight years (with the exception of two years in the TMT rally). The company looks to add value to sites it acquires and, following positive results, anticipates further growth in 2004.

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