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Fat of the land

24 August 2016 By George Hay

Britain’s housing crisis is hiding in plain sight. UK average house prices are over five time average earnings, according to Halifax data, and despite the shock of Brexit housing transactions were largely unaffected in July, according to official data released on Aug. 23. Persimmon’s 36 percent return on capital employed, revealed with the UK builder’s first-half results on the same day, is a sign that this is a malfunctioning market.

In theory, an environment in which companies make returns of this scale when they only need around 9 percent to meet their weighted average cost of capital – and thus investor expectations – should attract new entrants. One reason this doesn’t happen is smaller rivals went bust in the aftermath of the 2008 crisis, and can’t get access to finance from wary banks now. A bigger issue is Britain’s sclerotic planning system – politically motivated opposition to development makes it hard for developers to know whether consent will take months or years.

Builders typically deal with the uncertainty by factoring in a gross profit margin of around 20 percent when they sell a house. If land and construction costs make this unfeasible, they can attempt to maintain their selling price by controlling the supply of new houses they sell every year. Persimmon has 93,519 so-called consented plots of land, and said at its full-year results it has over six years’ supply on which to build its houses.

High returns today have to be weighed against poor returns in the past. Persimmon’s nine-year average return on capital is just under 15 percent, factoring in low returns following the 2008 crash. Rival Barratt Developments, which made a 24 percent return on capital employed in 2015, shows a similar trend. But the UK’s current figure of around 150,000 new houses a year is 100,000 off what’s needed. If builders didn’t need to make their 20 percent margins, they could get away with selling houses for lower prices than the 205,762 pounds average recorded by Persimmon in the first half.

That makes housebuilders’ profitability a political issue. Prime Minister Theresa May asserted on July 11 that Britain has a “housing deficit” between rich homeowners and stymied renters. That may not seem too different to what her predecessor David Cameron said. But May has also railed against policy being set for big business.

The new government may not be able to do much about the basic political problems caused by slow planning, which itself reflects that the majority of Britons own their own home and don’t want prices to fall. But if it senses that large builders’ returns are getting too high, there are levers to pull. It could capitalise a public sector bank to lend to smaller builders who can’t compete effectively, or it could build the houses publicly – like it used to do in the 1960s and 1970s, when 300,000 houses were routinely built annually. Both might make house prices fall.

May could also scrap the previous government’s Help to Buy scheme, in which the government guarantees the riskiest bits of high loan-to-value mortgages for first-time buyers. That helps keep prices high, and forces taxpayers to take the risk for the benefit of the few. It also gives builders an unnecessary leg-up – over 40 percent of Persimmon’s new volumes stem from those assisted by Help to Buy.

Housebuilders didn’t make the UK housing market as dysfunctional as it is. But having nearly collapsed in 2008, they now look strong enough to deal with a tougher operating environment. Persimmon has net cash. And, like peers, it also has an inbuilt defence mechanism against low prices – it can just stop buying new land and generate cash by running down what it has.

None of this would be very good for shareholders in the largest building groups. But builders privately admit that a market in which house prices grow steadily in line with inflation would suit them much better than one that comes with booms and busts. The need to make both the UK housing market and builder returns less excessive are two sides of the same coin.


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