December’s Halifax House Price Index showed that house prices rose by just 0.2% in the last month. This gives a quarterly change of 0.8%, with the report warning that “house price growth may slow over the coming months”.
That’s not surprising. Uncertainty surrounding Brexit, affordability issues and the potential for high inflation are all likely to weigh on the housing market in 2017. As such, house prices could flat line or even fall next year.
This doesn’t bode well for housebuilders such as Persimmon (LSE:PSN). Its financial performance is set to be hit by a flaccid housing market in the short run.
However, its low valuation takes this into account and in the long run the imbalance between demand and supply could lead to capital gains. Therefore, Persimmon could be a sound buy.
It’s difficult to find anyone who is bullish about the prospects for house prices in the near term. Perhaps the only positive factor in its favour is that there is a lack of supply.
This is keeping house prices artificially high in my view. While this offers a degree of protection from price falls, the weight of the problems facing the market could become overpowering in future months.
According to Nationwide the house price to earnings ratio is at its highest level since the credit crunch.
For example, according to Nationwide the house price to earnings ratio is at its highest level since the credit crunch. It stands at just below six times the average salary, which by historical standards indicates that a correction is imminent.
The last time it was this high, house prices fell by 15% – 20% during the global financial crisis and while they have recovered, they could easily fall back by a similar amount.
A lacklustre outlook
As well as being unaffordable for most people, house prices could struggle to rise due to Brexit uncertainty. The government is set to kick-off negotiations in Q1 2017 and judging by the tone of the EU’s chief negotiator, it is unlikely to be an amicable divorce.
The issues of freedom of movement and access to the single market are seemingly intertwined, so a hard Brexit may result. Uncertainty surrounding this possibility could lead to investors and first time buyers delaying house purchases.
Already, property investors are being hurt by tax changes. There will be no more mortgage interest relief for higher rate taxpayers within the next couple of years.
Buying an investment property also means that additional stamp duty of 3% is now due, while increasing regulation makes life as a landlord not quite as appealing as it once was.
Perhaps the biggest threat facing house prices, though, is that people will become poorer in 2017.
Inflation is due to rise to 2.7% according to the Bank of England, although other forecasts put the figure at 4% or above. This is due to a weak pound, which may depreciate against the dollar in particular as Trump’s low tax/high spend policies create a more hawkish atmosphere at Federal Reserve meetings.
In the UK, higher inflation is unlikely to be matched by wage growth over the medium term.
In the UK, higher inflation is unlikely to be matched by wage growth over the medium term. At a time when the economic outlook is uncertain because of Brexit and the question marks over access to the single market, many companies may choose to delay investment and cut costs, rather than reward staff with higher pay.
Therefore, real terms incomes may fall and leave many homeowners and first time buyers unable to afford the level of mortgage payments they could in 2016, even though interest rates remain at historic lows. This could cause the housing market to fall in future.
An opportunity among the uncertainty
It may seem as though investing in the property sector is a bad idea. However, the housebuilding sector has been hit hard since the referendum and now offers a wide margin of safety.
For example, Persimmon has a P/E of 8.9. This shows that while its EPS is forecast to fall by around 4% in 2017, the market has already priced this in following the company’s 15% share price decline in the last six months.
In the long run, Persimmon should benefit from the continued imbalance between demand and supply in the housing market. There are simply not enough houses being built, given population growth in the UK.
This should mean continued shortages of property which is likely to at least support prices over the long run. As a consequence, Persimmon and its peers should be able to generate rising profitability in future years, which has the potential to act as a positive catalyst on sector ratings.
Additionally, Persimmon is on target to meet its capital return plan. This was extended last year so that the company is now expected to pay out 110p per share per annum as a dividend over the next five years.
This equates to an annual yield of 6.4%, which is likely to become increasingly in-demand as inflation moves higher. Persimmon’s EPS of around 190p means that there is little threat to the capital return plan’s affordability, even if house price falls become a reality next year.
The UK housing market could be at the start of a very challenging period. The risks outweigh the rewards over the short run in my view.
A lack of affordability, uncertainty caused by Brexit, higher inflation plus low wage growth and changes to taxation mean that 2017 could witness a correction for house prices. Therefore, volatility in property stocks is likely to be high.
However, in my view the market has priced in these challenges. Persimmon has a low rating as well as a sound long term growth outlook resulting from a continued lack of supply of housing. Further, its income prospects are bright and this could become increasingly relevant as inflation picks up next year.
Therefore, while house prices are going nowhere over the medium term, Persimmon just might.