by Tajinder Dhillon.
Federal Reserve Chairman Jerome Powell has been consistent in his mantra of ‘higher for longer’ interest rates, while U.K. Governor Andrew Bailey has warned that it is ‘very premature’ to lower interest rates. While both banks share a similar view of higher for longer, the impact to the local housing market has been remarkably different.
In the U.S., the 525 basis point increase in the Fed Funds rate over the last 19 months has resulted in a 30-year mortgage rate rising to a 23-year high of 7.31% according to LSEG Datastream. The U.K. is not far behind, having raised rates by 500 basis points over the same period. A popular 2-year fix 75% loan-to-value mortgage is approximately 6.21%, reaching a 15-year high.
The impact of higher rates to a U.S. vs. U.K. homeowner are very different due to a) how mortgages are priced, b) term of mortgage, and c) mortgage porting.
U.S. mortgages typically are priced based on the mortgage-backed security market whereas U.K. mortgages are priced based on the Bank Rate (i.e. policy rate). When it comes to fixed vs. variable mortgages, U.S. mortgages tend to be fixed for 30-years, a far cry from the typical 2 or 5-year fix in the U.K. (longer maturities have begun to surface in recent years), while also acknowledging the presence of variable rate mortgages on offer. Mortgage porting is a concept which allows homeowners the ability to transfer an existing mortgage to a new property they wish to move into. In the U.K, this is a common practice but seldom in the U.S.
What does this all mean and how does this impact homebuilders? For U.S. homeowners who were able to refinance and lock into a 30-year fix mortgage prior to the rate hike cycle. they now have little incentive to sell their home in the current rate environment and are less impacted by higher rates compared to U.K. homeowners who will have to refinance sooner into a higher rate environment (or already feel the pain of higher rates if subscribed to a variable rate mortgage).
The behavior in U.S. homeowners has in turn impacted the supply of existing homes which has dried up, forcing potential homebuyers to enter the new-build housing market instead. We see this in the National Association of Realtors data, which shows a secular decline in existing home sales for single-family and condos since November 2021 and has declined 15.3% y/y.
To illustrate the benefit to new homebuilders, the Russell 1000 Home Construction index has risen by 56.7% over the last year compared to a 9.7% gain over the same period for the FTSE 350 Home Construction index. Using LSEG Workspace, we highlight the StarMine Combined Alpha Model (CAM) for various U.S. homebuilders in Exhibit 1.
Exhibit 1: StarMine CAM for U.S. Homebuilders
CAM combines all available StarMine alpha models in an optimal, static, linear combination. The StarMine models used in StarMine CAM are the Analyst Revisions Model (ARM), Relative Valuation (RV), Intrinsic Valuation (IV), Price Momentum (Price Mo), Earnings Quality (EQ), Smart Holdings, Insider Filings (U.S. only) and Short Interest (U.S. only). CAM is StarMine’s best performing alpha model to date.
Most homebuilders in Exhibit 1 have a CAM score (1-100 regional percentile ranking) in the top decile, which is a bullish signal. Moving to the Analyst Revision Model (ARM) column, every company has an ARM score in the top decile which indicates that analysts have been revising their estimates upward and is highly predictive of future revisions as the model incorporates analytics such as the StarMine SmartEstimate and StarMine Predicted Surprise.
ARM is a stock ranking model that is designed to predict future changes in analyst sentiment by looking at changes in estimates across EPS, EBITDA, Revenue, and Recommendations over multiple time periods.
The group also has a high Relative Value and Intrinsic Value score, indicating that these companies are ‘cheap’ based on valuation ratios such as Price to Earnings, Price to Book, EV/EBITDA, and Dividend Yield.
From an institutional perspective (i.e. Smart Money), most companies have a Smart Holdings score above 70, which is considered a bullish signal and highlights that these companies are likely to pass the ‘screen’ of institutional investors who look for companies based on multiple factors such as Price Momentum, Value, Analyst Revisions, Profitability, Growth, and Leverage.
Finally, looking at the sustainability of future earnings as defined by the Earnings Quality model, most homebuilders have a model score in the top quartile which highlights characteristics such as conservative levels of accruals, strong cash flow generation, and robust operating efficiency.
Exhibit 2 shows new single-family home sales, which have surged over the last fifteen months to 714,000 units (+31.5% y/y. +4.4% m/m), in the latest release from the U.S. Census Bureau. As mentioned earlier, as the inventory for existing homes has dried up, this will force individuals to enter the new housing market instead which is benefitting homebuilders.
Exhibit 2: U.S. New Family Home Sales
Moving over to the U.K, we see an opposite picture as shown in Exhibit 3. Potential homeowners are cautious on purchasing a new home as mortgages have become considerably more expensive and have passed-through much faster into the U.K. system as described earlier.
Housing activity has stalled when looking at new housing starts, falling to 37,000 homes in Q1 and a 27.3% fall from the peak in Q2 2022 (52,000). The number of new mortgages approved for a home purchase has also reached a 10-year low.
Exhibit 3: StarMine CAM for U.K. Homebuilders
Given the gloomy backdrop, many homebuilders have pre-announced negative revisions to top and bottom-line full-year expectations. We note in Exhibit 3 that analysts have reacted accordingly by downgrading estimates resulting in most companies having an ARM score below 30, which is considered bearish.
There has been a recent revival in share prices as indicated by the Price Momentum model as the outlook for inflation has improved from a peak of 11.1% last year to a current reading of 6.7%. Although CPI is still above 2%, the Bank of England held rates constant in its latest meeting on September 21. The committee indicated that the impact of monetary policy is making its way through the economy and expects inflation to continue to moderate. This was a positive announcement for homeowners who may feel that the end is near for future rate rises and provides a more certain outlook for financial planning, which in turn will benefit homebuilders.
With respect to financial planning, we use LSEG Datastream to show the financial burden on homeowners by showing how much first-time buyers spend take-home pay on mortgage payments. The average first-time buyer in the U.K. is spending approximately 39% of their take-home pay on mortgage payments, up from 27% in 2020 and significantly higher than the long-term average of 29.5%. For those who live in London, this rises to 65% which is a 33-year high.
According to Nationwide, the average home price is £259k and has fallen 5.3% y/y. The aggregate U.K. home price to earnings ratio is 6.4x, above the long-term average of 4.7x. For first-time buyers, the ratio falls to 5.5x and for first-time buyers in London, rises to 10.3x.
Exhibit 4: % of Income Households spend on Mortgage Payments
Although the Bank of England has indicated that the effects of monetary policy are making an impact on the economy, headline inflation is still well above 2%. The latest release shows headline y/y CPI falling from a peak of 11.1% last year to 6.7%, while core CPI is at 6.2%. According to the Interest Rate Probability App in LSEG Workspace, markets are pricing for rates to be held at the current level for the rest of the year with 69.0% probability of no hike for the November 2 meeting and a 58.8% probability of no hike at the December meeting. We see a similar picture in the U.S., with an 81.4% probability that rates are held constant at the November 1 meeting and a 60.7% probability that rates will not rise in December either.
The mantra ‘higher for longer’ is being adhered to for now.
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