2 reasons why estate agents could still make sense for investors

It’s been a bad week for estate agents. In his Autumn Statement, Chancellor Phillip Hammond announced plans to ban letting agents from charging tenants fees. Underlying market conditions seem to be slowing too.

On Thursday morning, shares of leading agency group Countrywide (LSE: CWD) fell by 13% when markets opened after the firm warned that earnings are likely to be at the lower end of expectations this year.

Countrywide expects house sales to fall by 6% in 2016 and to fall further in 2017. However, this slowdown is expected to be partially offset by growth in the rental market. This hope seems reasonable. While Countrywide’s housing sales fell by 1% during the third quarter, lettings rose by 14%.

This year’s biggest fallers?

Shares of Countrywide have fallen this week as have shares of London-focused firm Foxtons Group (LSE: FOXT) with Foxtons down by 40% so far in 2016, while Countrywide is down by 55%.

Is this decline likely to continue, or are there reasons to think that the sell-off has gone too far?

A meaningless gesture?

Some industry analysts believe Mr Hammond’s decision to ban letting agents from charging tenants was simply a crowd-pleasing move.

They argue that it will have little real effect on housing affordability. Costs previously charged to tenants — such as credit checks — will now have to be met by landlords or letting agents. Any extra costs for landlords are likely to be reflected in rent bills. Estate agents are expected to continue making healthy profits from lettings, even if these aren’t as profitable as house sales.

I tend to agree. Estate agents have a pretty good track record when it comes to survival. In the Yorkshire town where I lived during the financial crisis, I don’t remember any estate agents closing down.

Strong fundamentals?

How strong are estate agents, financially? Foxtons certainly looks reasonably healthy. The group’s dividend has been consistently covered by free cash flow since its flotation. At the end of June, Foxtons still had net cash of £4m, and no debt.

Although the group’s operating margin has fallen from a peak of 30.9% to 22%, this is still pretty high. Its cash-backed 4.9% forecast dividend yield makes it possible to see why the shares are still trading on 16.5 times forecast earnings.

At first glance, Countrywide looks cheaper. I’ve taken a cautious view, and assumed that consensus earnings forecasts will be cut by 10% following today’s news. This would give Countrywide a forecast P/E of 7.8 for the current year, with a prospective yield of 7.8%.

The group’s decision to put acquisitions on hold should improve cash flow, and help to support the dividend. However, Countrywide’s net debt of £258m is quite high relative to earnings. Further increases would be a concern, in my view.

Buy or avoid?

So with a ban on tenant fees probably having little effect estate agents’ profits and both companies remaining in reasonable shape, financially there are two good reasons to invest. 

But there’s also a risk the outlook will deteriorate further, which is why I’d wait a little longer before hitting the button. Earnings guidance could continue to fall and lettings aren’t generally as profitable as house sales, which seem to be slowing.

Dividend payouts may still be cut to preserve cash. So while I believe estate agencies will remain profitable, robust businesses, I think it’s too soon to dive in just yet.

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Roland Head 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.