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Will London’s Sky-High Real Estate Prices Send Telford Homes Plc & Foxtons Group Plc Soaring?

Shares in London homebuilder Telford Homes (LSE: TEF) have risen 337% over the past five years on the back of the buoyant (some would say overheating) capital property market. Yet the shares look cheap at 9 times forward earnings with a whopping 3.9% yielding dividend on offer. Have City analysts missed a stellar small cap, or is there disaster on the way for Telford?

Focusing on non-prime London locations where prices are more reasonable, and thus more sustainable in the long term, has been a solid play for Telford. Through organic growth and acquisitions the company has built up a £1.5bn development pipeline with forward sales of £700m. Charging up to 20% of the price of a home in deposits and other fees means that the company has freed up significant cash flow years before developments are even completed.

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A laser focus on costs has also brought gross margins up to 27.6%, above internal long-term goals and ahead of larger competitors. However, there are some clouds on the horizon. Net debt at the last reporting period was £50.4m, representing a gearing ratio of 37.3%. This is significantly more debt than larger homebuilders have piled on, having learned the lesson during the lean years that high leverage and low demand is a bad combination.

If London housing prices go south, gearing of 37% would be a scary sight for management and shareholders alike. I may be overly cautious, but high debt levels and relying on housing prices continuing to defy gravity makes me wary of Telford’s ability to continue performing as well as it has. While the company has built up a strong portfolio and relatively lean operations, housing prices will come down eventually and Telford is far too tied to them to make me consider investing in the homebuilder at this point in the cycle.

Multiple challenges

Foxtons (LSE: FOXT), the London-only estate agency, has struggled since going public in 2013 with share prices down 40% from their IPO level. While the company has continued to increase the top line, it’s increasingly beginning to feel the bite of a slowdown in its traditional high-end market.

Pre-tax margins fell from 32.1% to 30.7% over the past year as expensive home sales in central London fell, forcing the company to expand into outer London. Foxtons plans to continue with this and foresees expanding its number of locations from the current 62 offices to over 100 in the near future. Although this will help to keep the top line growing, I have concerns for what this will do to profits. Pre-tax profits already fell 2.6% year-on-year as the company discovered that lower home prices in non-core postcodes led to lower margins.

The largest worry I have for Foxtons is the long-term threat it faces from online-only and hybrid estate agents such as Purplebricks. These disruptive, low-overhead entrants to the industry offer sellers fees that are on average a quarter of what Foxtons and other high street agents charge. As increasing numbers of homeowners balk at paying 2.5% to 3% of their windfall to an agent who does little more than list the property on Rightmove and Zoopla, the traditional estate agency model could be facing an existential threat. With short and long-term problems looming, I don’t believe Foxtons shares will be reversing its decline anytime soon, even if the London property market continues to chug along.

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