The Housebuilding sector is inherently cyclical. Any suggestion that the current upswing is different from the last should be viewed with caution. Over the last three years, housebuilders have seen their shares perform strongly as recovery has come through. However, we believe that this stage is coming to a close and many management teams in the sector are now beginning to prepare for the next cyclical downturn, which could occur any time from 2016. We now expect that capital growth will be replaced by income growth.

The housing cycle: recurring periods of peaks and troughs
According to the Royal Institute of Chartered Surveyors (RICS), property cycles range from four to 12 years, with an average of eight years, as measured by peaks and troughs in performance, although some authorities refer to 18-year property cycles. RICS recently postulated that house prices could continue to rise until 2020. In the UK, where housing market volatility is an important factor in the economy, residential peaks and troughs are commonly referred to as boom and bust.

There have been examples of boom and bust in the 1970s, 1980s and 1990s. Following the economic downturn from 2008 onwards, there has been a resurgence of the UK housing market, kick-started by the government's Help-to-Buy schemes, and a strong recovery in operating margins at quoted housebuilding companies. The equity market has historically looked well into the future in terms of pricing both future returns and inflexion points. Therefore, the key to the sector's performance is to estimate when the next downturn will occur and try to pre-empt this before the shares of housebuilders fall out of fashion once more.

When might the current cycle peak?
Peak margins in the last cycle reached an average of 17.5% for the eight companies we have looked at, falling to an average of 4.0% in 2009. Since then, they have recovered to an average of 14.2% in 2013, with over 16% in prospect for the current year. On our estimates, the average peak margins of the last cycle will be exceeded in 2016, driven by the proportion of land that has been acquired since the last recession and the amount of strategic land held. However, we think that operating margins are set to peak soon due to rising build costs, including land, materials and labour costs, especially if average selling prices are insufficient to offset these.

Our view is that 2016 could well signal the peak. This would be nine years after the previous peak and would also coincide with the first anniversary of the next general election. It is unlikely that either interest rates will go up before then or that there will have been much change to the Help-to-Buy schemes. However, the second Help-to-Buy scheme (mortgage guarantees for houses worth up to £600k) was originally scheduled to have a three-year life from its creation in April 2013. In addition, it is increasingly likely thatinterest rates will rise over the next three years.

What could cause the current cycle to lengthen?
The government has stated its desire to increase the supply of housing and most commentators agree that there is a significant shortage of new housing at present. Although the government's Help-to-Buy (H2B) scheme acted as a catalyst for the sector and housebuilders are currently increasing the supply - this is not enough. So where are the bottlenecks? The large housebuilders, which have a market share of 56% between them, are unwilling to over-commit if the cycle turns down, but perhaps other smaller enterprises could fill in the gap between demand and supply. However, banks have been slow to lend to small builders, although this could ease as the 2014 Budget introduced the £500m Builders Finance Fund to smaller enterprises to help them build an additional 15,000 homes.

Many housebuilders still cite planning permission as the principal reason for not building more quickly. While the government plans to make it easier for change of use from light industrial and warehouses to residential, and aim to speed up the planning process, it is still too slow to meet the demand for housing. Despite the increase in the number of housing starts to 120,450 in 2013, this remains well below the last peak in March 2006, which was over 180,000.

Conclusion
There are two schools of thought on the Housebuilding sector. While underlying demand for new homes exceeds supply, and while the number of new housing starts is well below the number produced at the peak of the last cycle, then there is still upside ahead. Conversely, the housing cycle may turn down in due course and when it does, it could do quickly. With the potential risks of rising interest rates, tightening mortgage lending criteria and falling demand from overseas buyers, we believe that the upside is now limited. While we would agree that data is not yet suggesting a turning point in the market, the ratings of the shares in the sector suggest that capital growth will be more difficult to achieve.

Housebuilding stocks have significantly outperformed the UK over the last three years. The FTSE 350 Household Goods sector has increased by 95% since February 2011, when the index was reconstructed, against a 13% rise in the FTSE 350 in total. In the same period, the share price of Galliford Try has increased by 240% and Taylor Wimpey by 193%. The sector is now trading at nearly twice its tangible net asset value and well above the long-term average of 1.2 times physical worth. The average prospective P/E ratio is now 11.3 times earnings to December 2014, which appears to be pricing in the best of all possible worlds.

We believe that portfolios looking for capital growth should now consider reducing holdings in the Housebuilding sector as the majority of the recovery has now been seen. However, as the companies now look to return surplus cash to shareholders, total returns are likely to be underpinned by the prospective dividend yields, i.e. income growth will take over from capital growth. It could be time for growth-orientated portfolios to exit, while those seeking yield should stay on board.

Stephen Williams
Head of Mid Cap Equity Research

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