Housebuilders' spectacular returns still have further to go, just look at the lagging price of land, says UK fund manager

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Housebuilder stocks have been one of the great post-recession success stories, with many companies seeing share price rises of 300 per cent or more over the past five years.

Brian Cullen is manager of the SWMC UK Fund, an all cap equity fund.

He argues that despite already enjoying these spectacular returns, housebuilders are in a 'perfect storm,' with high levels of housing demand, a competitive mortgage market and - crucially - the lagging cost of land combining to create a favourable environment for the sector.

Perfect storm: Strong housing demand and the lagging cost of land are boosting housebuilder returns

Over the five years to the end of 2015, UK housebuilders have delivered spectacular returns of almost 440 per cent, including dividends; far ahead of the meagre 34 per cent delivered by the FTSE All Share. It has been a golden era.

This is not the first time housebuilders have done well. The sector returned more than 250 per cent between 2003 and 2006, against a 95 per cent rise for the broader market – but the scale of the recent gains raises some questions.

The UK’s consumer-led economic recovery of the last few years is not, by itself, enough by way of explanation. We believe the answer lies in the surprising absence of land price inflation. 

House prices have risen sharply, but the prices of the plots that houses are built on have not.

The impact on sector margins and return on capital has been startling. For example, the return on net operating assets achieved by Taylor Wimpey has risen from 5 per cent in 2010 to 27 per cent today.

Land prices significantly lagging

The price a housebuilder charges for its product is the sum of a number of parts. 

Roughly speaking, 55 per cent of the price of a house is the cost of building it, 20 per cent is the cost of what it is built on and 5 per cent goes on overheads. This leaves 20 per cent as the company’s profit margin.

Historically, previous periods of strong housing demand growth and resultant house price inflation have been accompanied by increases in the price of land, limiting or potentially wiping out the margin benefits.

Lagging behind: House prices rose 20 per cent between 2010 and 2015, but land prices only rose 1 per cent

In fact, previous cycles have often seen land prices rising before house prices. For instance, house prices rose by about 225 per cent between 1991 and 2007, whereas land values increased by approximately double this amount.

However, something very unusual has happened over the past half-decade. House prices rose by nearly 20 per cent between December 2010 and December 2015, but at the same time land prices struggled to rise a scant 1 per cent. 

Far from outstripping house price inflation, land prices have actually lagged substantially behind.

For example, each house sold by Taylor Wimpey in 2015 cost the company about £42,400 per plot. 

While slightly higher than the £39,600 per plot in 2012, the rise was far lower than the increase in the prices of houses built on those plots, which were up nearly 30 per cent.

This dynamic is puzzling, as land prices usually move with house prices. 

The only reason for this to not happen would be if builders were choosing to walk away from open market land even if it could generate an attractive margin, or if there was a dearth of alternative contractors to build on the land. 

Lack of competition: The number of housebuilders has steadily fallen despite the higher returns on offer

In fact – surprisingly – both these elements have been apparent in recent years. 

In 1988 there were 12,430 housebuilders building fewer than 500 houses a year, in 2015 there were only 2,490. There has been no recovery in the number of smaller builders since the crisis, despite the high returns generated by the big builders. 

The reason for this is primarily linked to a lack of financing: banks will simply not lend to small operators.

Cullen: Housebuilders don't just rely on cyclicality

The bigger builders are also filling this void. Management teams are focusing less on growth and more on sustainable returns and high cash payouts to shareholders. 

This is one reason why, despite the extraordinary share price runs since 2009, the sector on average is yielding nearly 6 per cent, higher than it did at any point in the previous cycle.

A sustainable structural dynamic

The recent good fortune of the UK housebuilders goes beyond simple demand cyclicality. The companies have benefited from a perfect storm. 

High levels of housing demand, driven by demographic trends, has been enabled by a competitive mortgage market, with additional spurs from government initiatives such as Help to Buy.

However, the land market is the most singularly unusual element of this cycle, enabling returns to exceed expectations. This element also displays a degree of sustainability, as some of its reasons are structural rather than cyclical.

However, the industry is still confronted by possible headwinds, such as the potential for Britain to leave the EU. It would appear hard for returns in the next five years to match what they have been in the past five years. 

Despite this, if the land market remains benign, the housebuilder sector will at least still have one very important factor still working in its favour. 

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