MENU

Why this number tells us that house builders must crash

Image: Berkeley Group. Fair use

Housebuilding stocks have enjoyed a fantastic run in recent years, at least until the shock Brexit result. In the five years to 31 December 2015, Berkeley Group Holdings (LSE: BKG) saw its share price triple from 900p to 3600p. Barrett Developments (LSE: BDEV) did even better, rising sixfold from 88p to 635p over the same five-year period. 

It cannot last.

Boom and doom

Rock-bottom borrowing costs and rising demand from the fast-growing UK population are at the root of these stunning growth rates. Both factors are still in place today, which explains why house prices have stubbornly refused to crash, frustrating the doom-mongers year after year after year.

London prices have also been driven by a surge of overseas investment from Greece, Italy, China, the Middle East, as the world’s wealthy treats property like gold bricks. Berkeley and Barrett are both heavily exposed to the London property market, and have done particularly well as a result.

Double digit trouble

The glory days may now be over and the following number shows why: the house price-to-earnings ratio in London has just exceeded 14 times average income for first time ever. The average Londoner must now pay a record 14.2 times their annual gross salary to buy a home, more than double the ratio for the UK as a whole, according to new data from Hometrack. That is double the UK ratio of 6.5 times. 

The average London property now costs £482,800, up 86% since 2009. The average London salary is £33,720. Property is beyond unaffordable for the average Londoner. It’s less of a problem for existing homeowners, who are sitting on vast reserves of spare equity, but it will squeeze next generation of buyers out of the market, unless they have parental help.

The problem isn’t confined to London. The ratio tops 13 times earnings in Cambridge and Oxford, but it is most acute in the capital. Yet prices in the capital still grew 9.1% in the year to October, even if that was the lowest rate in three years.

Cash or crash?

While interest rates stay low and foreign investment high, a crash may be averted. Berkeley is still projecting £2 billion pre-tax profit over the three years to 30 April 2018. It says reservation rates have improved since the Brexit shock. The housing shortage continues, and the building plans announced in Chancellor Philip Hammond’s Autumn Statement will do little to change that.

Barratt’s trading update earlier this month was similarly positive, reporting that overall market conditions remained healthy, reservations are rising, and forward sales were up 4.3% to £2.65 billion. This covers the post-referendum period from one July to 13 November. On Monday, it paid out a record £248m in dividends.

Trumped

Berkeley currently trades at a reduced valuation of 9.14 times earnings and yield a tempting 8.22%, while Barrett is at 8.59 times and yields 3.89%. Property market uncertainty is therefore partially priced in, but I would still hesitate to buy house builders today.

The house price-to-earnings ratio will only worsen with UK wages rising at 2.3% a year while regional city house prices are surging by 8.4%. It means that nvestors in property stocks are gambling on interest rates staying low, well, pretty much forever, to support this imbalance. If the Trump reflation drives up global borrowing costs, or Brexit bites next year, it could prove a losing bet.

Don't fret about Brexit

The doom-mongers said Brexit would be a disaster for the UK, but the FTSE 100 surprised everybody by rebounding to new highs.

Still, it is early days and the turbulence may return with a vengeance once Prime Minister Theresa May triggers Article 50.

This BRAND NEW special Motley Fool report sets out exactly what Brexit means for your portfolio, and how you can take advantage by picking up top company stocks at bargain basement prices.

Don't fret about Brexit any longer but click here to read this no obligation report. It will be yours in moments and won't cost you a penny.

Harvey Jones has no position in any shares mentioned. The Motley Fool UK has recommended Berkeley Group Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.