House builder Berkeley Group can bounce back from Brexit

Despite the Brexit vote, house builders remain an attractive investment proposition. With its high, well-covered yield and low valuation, Berkeley is a star buy for the long term in my opinion. Brexit may cause underperformance in the short run as well as a volatile share price, but Berkeley’s overall risk/reward ratio has significant appeal.

According to the Halifax house price index, UK house prices have fallen by 0.1% in the last three months. That’s to be expected. The EU referendum has fundamentally changed the outlook for the UK housing market. It is likely to endure greater volatility and more uncertainty as Brexit gradually becomes a reality over the next couple of years. This may mean house builders such as Berkeley Group (LON:BKG) endure a difficult period. However, I believe that in the long run Berkeley will deliver high total returns.

The impact of Brexit on the UK economy

Brexit hasn’t happened yet, but already its effects are being felt. The Bank of England reacted swiftly to give its assessment on how it will impact on the UK economy. It believes that the rate of unemployment will increase by around 50/60 bps to 5.6% and that UK GDP growth will be marginal in 2017. The effect of this on the UK housing market is likely to be negative. If more people are out of work and businesses are not growing and investing as they have been in recent years, demand for housing could fall.

In tandem with its bearish outlook, the Bank of England also cut interest rates in response to the EU referendum. This will help to improve the affordability of housing in so far as mortgages will be less costly to service for new buyers and those on tracker mortgages. Further, the Bank of England has made it clear that maintaining the availability of credit throughout any financial downturn is a key priority. This means that the housing market may experience an uncertain period, but mortgage availability and affordability should remain relatively robust.

One effect of a looser monetary policy is a weakening of the pound. However, the main reason for its historic low versus the dollar (the exchange rate is currently £1/$1.22) is fear surrounding Brexit. This has caused investor and business confidence towards the UK to plummet. The chances are that further falls in the value of the pound will take place because as Brexit negotiations continue, there is likely to be even more uncertainty surrounding the outlook for the UK economy.

A weaker pound, however, is good news for the UK property sector and in particular for Berkeley. It means that houses are cheaper for foreign investors. For a housebuilder which focuses on prime residential such as Berkeley, this could positively catalyse its sales. Although it may take time for this to take place since the pound is falling fast and foreign investors may wait for it to bottom out, over the medium term prime London property in particular should be given a boost due to its ‘bargain’ status.

Housing fundamentals remain strong

One of the central reasons for UK housing growth over the last three decades has been an imbalance between demand and supply. Put simply, there are not enough houses being built for the population growth of the UK.

Evidence of how this situation has worsened can be seen in the fact that the UK’s population growth rate has increased rapidly. Thirty years ago the UK’s population was increasing by around 100,000 per year. In the last few years that figure has consistently been above 400,000 per annum. In the same time period the number of new houses built per annum has fallen steadily from over 200,000 per year in 1985 to less than 150,000 per year.

Housing fundamentals are likely to improve yet further. The UK’s population is expected to grow at an annualised rate of around 440,000 over the next eleven years on its way to hitting 70 million in 2027. The government’s plan thus far has been a focus on demand side policies such as Help to Buy, rather than supply side policies. This means that Berkeley and its peers should benefit from improving housing market fundamentals over the medium to long term.

Brexit’s potentially negative impact on the UK economy could cause housing to become increasingly unaffordable for UK residents. Already, the house price to average earnings ratio stands at its highest level since the credit crunch. It hit 5.9 this year and has only ever been higher during the credit crunch, which was followed by a 15-20% slump in house prices.

However, the increasingly loose monetary policy adopted by the Bank of England makes servicing debt easier. This means that people should be able to borrow a higher multiple of income, which could allow the house price to earnings ratio to reach new all-time highs in the short to medium term.

Berkeley Group still offers attractive total returns

A lower interest rate means that higher yielding stocks should gain favour among income-hungry investors. On this front, Berkeley has significant appeal. It is aiming to pay out £10 per share over the next five years in dividends. This works out as an annualised dividend yield of 7.1% which is almost twice the FTSE 100’s yield of 3.6%. Berkeley’s dividends are also likely to be well covered, since EPS in the current financial year and in 2017 is forecast to be in excess of 380p per share. This provides dividend coverage of around 1.9 times.

Given the uncertainty facing the UK housing market, it is of little surprise that Berkeley has a relatively low valuation. Its P/E ratio is 9.1 but is expected to fall to 6.2 when using the current year’s forecast EPS. In my view, this shows that even if the UK housing market endures a difficult period because of Brexit, Berkeley’s share price may not be hit all that hard.

Berkeley remains focused on the prime sector of housing and this will benefit from a weaker pound that makes such properties more appealing to foreign investors. Further, Berkeley should benefit from an exacerbation of the imbalance between demand and supply which is likely to support UK house price growth over the next decade.