Over the five years to the end of 2015, UK housebuilders have delivered spectacular returns of almost 440 per cent (including dividends); far ahead of the meagre 34 per cent of the FTSE All Share. It has been a golden era. 
While this is not the first time housebuilders have done well – with the sector returning more than 250 per cent between 2003 and 2006, against a 95 per cent rise for the broader market – the scale of the recent gains raises some questions.
The UK’s consumer-led economic recovery of the last few years is not, by itself, enough by way of explanation. We believe the answer lies in the surprising absence of land price inflation. House prices have risen sharply, but the prices of the plots houses are built on have not.
Performance of indices over 5yrs
Source: FE Analytics
The impact on sector margins and returns on capital has been startling. For example, the return on net operating assets achieved by Taylor Wimpey has gone from 5 per cent in 2010 to 27 per cent today.
Land prices significantly lagging
The price a housebuilder charges for its product is the sum of a number of parts.
Roughly speaking, 55 per cent of the price of a house is the cost of building it, 20 per cent is the cost of it is built on and 5 per cent goes on overheads. This leaves 20 per cent as the company’s profit margin.
Historically, previous periods of strong housing demand growth and resultant house price inflation have been accompanied by increases in the price of land, limiting or potentially wiping out the margin benefits. In fact, previous cycles have often seen land prices rising before house prices.
For instance, house prices rose by about 225 per cent between 1991 and 2007, whereas land values increased by approximately double this amount.
However, something very unusual has happened over the past half-decade. House prices rose by nearly 20 per cent between December 2010 and December 2015, but at the same time land prices struggled to rise a scant 1 per cent. Far from outstripping house price inflation, land prices have actually lagged substantially behind.
Source: Knight Frank and Nationwide
For example, each house sold by Taylor Wimpey in 2015 had cost it about £42,400 per plot. While slightly higher than the £39,600 per plot in 2012, the rise was far lower than the increase in the selling prices of the houses built on those plots, which were up nearly 30 per cent.
This dynamic is puzzling, as land prices do usually move with house prices. The only reason for this to not happen would be if builders were choosing to walk away from open market land even if it could generate an attractive margin, or if there was a dearth of alternative contractors to build on the land. In fact – and surprisingly – both these elements have been apparent in recent years.
Source: Home Builders Federation and Peel Hunt
In 1988 there were 12,430 housebuilders building fewer than 500 houses a year, in 2015 there were only 2,490. There has been no recovery in the number of smaller builders since the crisis, despite the high returns generated by the big builders. The reason for this is primarily linked to a lack of financing: banks will simply not lend to small operators.
The bigger builders are also filling this void. Management teams are focusing less on growth and more on sustainable returns and high cash pay outs to shareholders. This is one reason why, despite the extraordinary share price runs since 2009, the sector on average is yielding nearly 6 per cent, higher than it did at any point in the previous cycle.
A sustainable structural dynamic
The recent good fortune of the UK housebuilders goes beyond simple demand cyclicality.
The companies have benefited from a perfect storm. High levels of housing demand, driven by demographic trends, has been enabled by a competitive mortgage market, with additional spurs from government initiatives such as Help to Buy.
However, the land market is the most singularly unusual element of this cycle, enabling returns to exceed expectations. This element also displays a degree of sustainability, as some of its reasons are structural rather than cyclical.
However, the industry is still confronted by possible headwinds, such as a possible Brexit. It would appear hard for returns in the next five years to match what they have been in the past five years.
Despite this, if the land market continues to remain benign, the housebuilder sector will at least still have one very important factor still working in its favour.
Brian Cullen is manager of the SWMC UK fund. All the views expressed above are his own and shouldn’t be taken as investment advice.
