UK property market comes back to life, says Old Mutual’s Watts
As the UK property market comes back to life, the UK mid-cap equity market is increasingly the place to find interesting opportunities, according to Richard Watts,portfolio manager of the Old Mutual UK Mid Cap Equity Fund.
Housing has a unique place in the UK economy. There is a special sense of fulfilment in home-ownership. ‘First-time’ buyers have a priority on the political agenda, while rising home values translate to near-instant voter gratification. A revival in the housing market is front-page news.
This national attitude to our homes creates a number of anomalies. One is the traditional approach to investing in the housing market through direct purchase, buying or upgrading a home or taking on buy-to-let. Home-ownership can be immensely rewarding, but a house is a particularly illiquid investment, while mortgages create a conduit from Bank of England base rates to disposable income that is short, brutal and sometimes nasty.
The flotation of Foxtons, the London-area estate agent, is a sign that the equity market is increasingly providing an alternative route to participation in the property market. A basket of shares might not keep you warm at night, or not in a literal sense, but it is a lot more liquid, shouldn’t require a six-figure mortgage and its sensitivity to interest rates is a little less direct.
The Foxtons IPO was heavily over-subscribed, rising 16% on the first day, valuing the business at over £650m. Foxtons have some 40 offices, mainly in central London. It is an exceptionally well-run company, with special strength in marketing. The average price of its house sales is £400,000, which puts it in the sweet spot in terms of transaction growth as the recovery develops. It is the right section of the market for the second phase of Help to Buy, which will provide mortgage indemnity for homes worth up to £600,000. In our view, Foxtons is in a position to increase its footprint potentially to 100 offices and possibly more.
Foxtons is not the first estate agent to come to the market. Countrywide floated in March and has outperformed the FTSE All Share (ex investment trusts) by 40% since then (to 24 September). Savills, since its near-term trough in the midst of the eurozone crisis on 4 October 2011, has outperformed the FTSE All Share by 134%.
Estate agents are an interesting and expanding area of the equity market, but the heart of the sector in equity terms is the housebuilders. The sector has seen tremendous outperformance in recent years, with key companies such as Persimmon and Barratt Developments, which over the past three years have outperformed the FTSE All Share by 126% and 156% respectively. In our view, despite inevitable set-backs, the sector should continue to offer robust, market-leading returns.
Current demographics suggest the demand for new housing in the UK should run at around 260,000 units per year, but the market is only supplying half that, around 130,000. It is highly unlikely that supply will reach, let alone overtake demand, on almost any scenario. The block has been financing, with capital constrained banks requiring significant cash deposits. The government – and everybody who reads a newspaper or watches television or listens to the radio – is aware of this and given the economic benefits of house-building it has taken some bold measures.
The first phase of Help to Buy, under which the government lends new home-buyers 20% of the price towards a 25% deposit, is already having a significant impact, with 30% of new-built homes being reserved through the scheme. The second phase starts in 2014, providing mortgage guarantees, and should stimulate the market further. The schemes are intended as temporary kick-starts, but the first phase is proving so popular its £3.5bn funding is likely to expire at some point in 2015 – a date whose proximity to the next election suggests to us that it could be replaced, should need arise, by something either as good or better. In the meantime, the banking sector should by then be further on the road to recovery, opening the possibility that affordable commercial mortgages will increasingly become available.
A less publicised but important change is in planning law. Under the new National Planning Policy local authorities are required to maintain a five year plan. In the absence of such a plan, where any planning application is denied, it will be automatically granted on appeal. This has unleashed fresh tracts of buildable land, a flow unlikely to be completely staunched as plans come to be adopted more widely. So much for the environment – what about the stock specifics? Housebuilders have done well – is there more to come? In my view there is and the numbers tend to support a positive argument. The key decision is whether the UK property market will continue to recover into the medium to longer term.
Let’s take Barratts as an example. We believe they are capable of achieving a return on equity of around 18% on a 2-3 year view as they build out land acquired in recent years at attractive profit margins. We expect the industry to be building around 170,000 units a year by the end of this period, significantly higher than current levels but still well below the demographic requirement. From this level, we believe it fair to assume that Barratts’ unit sales can continue to grow at relatively modest minimum of 4%-5% a year – given natural demand, government support and ongoing economic recovery – that would leave Barratts with around 75% of its earnings free to distribute as cash to shareholders, which at current share prices implies a dividend yield at around 10%. That is a high yield for a well-run business in a growing market and we would expect most investors to accept something significantly lower, possibly down to around 5% – and that, in turn, implies a much higher share price.
One of the most satisfying aspects of investing in UK mid-cap equities is the dynamism and variety of the opportunities. As the property market comes back to life, it is likely there will be mid-cap companies there to reap the benefits. And as they say in the property business – we are eager for further developments!