Confidence Increases For Oz Housing Developers

This story features STOCKLAND, and other companies. For more info SHARE ANALYSIS: SGP

-Housing demand lifts
-Potential for developer upgrades
-Lend Lease, Peet well placed
-Land banks likely to be reduced
 

By Eva Brocklehurst

Australia's housing market is finally starting to lift. Building approvals are trending higher, up 19% from the mid 2012 nadir. Prices are also on the rise. This has caused brokers to take a look at how residential builders are placed in the scheme of things.

Housing finance approvals show that investors are coming back to the market. Investor finance approvals for new and existing housing in the three months to August 2013 reached an all time high in dollar terms. As falling interest rates and strong rental growth across most capital cities led to improved cash flow outcomes for residential investors, this class of buyer has become increasingly active.

Bad news? It's patchy. Moreover, investors have been the key driver of the current housing recovery, accounting for up to 45% of housing finance approvals, and prefer to buy established houses. First home buyers are a major source of demand for new housing stock and they are struggling to enter the market. To BA-Merrill Lynch, this makes it most important to monitor the housing vacancy rate in the rental market for any signs of oversupply, given a lot of the apparent demand is really just focused on the established market.

The recent building approvals data shows the four major states are also at very different stages of the housing cycle. Victoria has had a large amount of supply coming to market over the last four years while the rest lagged. Queensland and Western Australia have lagged particularly because of strong population growth at 2.0% and 3.1% per annum respectively. The recent high level of housing construction in Victoria is unwinding, with approvals down 22% on a year ago.

In contrast, NSW has made a strong recovery, although off a very low base. Rental conditions remain relatively tight with vacancies under 2% and rents growing at 5-10% per annum. Western Australian starts have recovered strongly, but could be peaking, with rental vacancy rates lifting to 3.4% over the last 12 months and suggesting the supply of housing has now largely met demand. Parts of Queensland are still working through previous high levels of supply and subdued consumer sentiment.

Merrills has raised its national FY14/15 housing start forecasts to 160,000 per annum and expects, for the developers, this positive short term outlook will translate to increased confidence in the earnings outlook for FY14 and FY15, with reduced risk of impairments and greater chance of earnings upgrades. Australand Property's ((ALZ)) near-term earnings are skewed towards major apartment projects but earnings upside is limited in Merrills' view, despite a relatively higher proportion coming from residential development. Of the large cap developers, Stockland ((SGP)) is most likely to see upgrades to earnings forecasts near term, given the shorter production cycle of its land developments versus the apartment projects. Moreover, the company will be hampered by previous project impairments, meaning a portion of the increased sales will not contribute to earnings.

Most developers are diversified, so earnings uplift from improved housing accounts for less in percentage terms. Peet ((PPC)) is the only pure developer in the broker's coverage and has scored an uplift to earnings forecasts of 4.1%. Merrills prefers Peet and Lend Lease ((LLC)) as exposures to the housing recovery. Lend Lease is a sizeable developer and in the middle of a major ramp up in projects, with 11 apartment launches underway and another five expected in FY14.

On the other side of the coin, the broker has downgraded Mirvac ((MGR)) to Neutral from Buy as the stock is now trading in line with valuation, notwithstanding the stronger housing outlook. Merrills needs to see a more robust housing recovery, or further progress on office and retail opportunities, to become more positive on Mirvac. Mirvac has secured over 75% of FY14 development earnings, and is on track to achieve its 10% development return target. NSW was the biggest contributor in the quarter at 55% of settlements and a similar level of pre-sales.

Macquarie thinks Lend Lease is well placed for growth and residential building is clearly in recovery, albeit off a low base. Lot sales in the September quarter were up 20% on the June quarter, one apartment project will settle in FY14 and the RNA showground in Brisbane will contribute 200 units in FY14. Residential may make up just 10% of Lend Lease's earnings but the signs are encouraging for this segment in Macquarie's opinion. Credit Suisse has also increased Lend Lease's Australian residential earnings multiple to 12.5 times following the rise in first quarter sales and remains comfortable with an Outperform rating. In the other corner is Citi. The broker has now found Lend Lease's risk/reward less compelling following the share price re-rating and downgraded the stock to Neutral from Buy.

Lend Lease has 1,500 lots current under construction and the majority will settle in FY16. Hence, UBS expects 14% earnings growth in that year, driven by the settlement of major blocks including Barangaroo and Elephant & Castle. Moreover, the company has limited need to allocate new capital or make land and infrastructure acquisitions, with a sufficient backlog of zoned (55,545) lots, which at the current run rate of 2,500 sales per annum would support earnings for around 20 years, in UBS' calculations.

Longer term, Merrills is more cautious and suspects the current housing improvement is cyclical rather than structural. The approval process remains cumbersome, there are high costs for developer infrastructure and limited land available. The areas of high demand for housing are likely to stay as such. Moreover, the broker notes Stockland, Mirvac and Australand are all looking to reduce land holdings in a bid to boost returns on investment capital.

One thing a better market should do is help developers improve the return on invested capital, which has been lagging at around 5% in recent years. Merrills expects it will allow those impaired projects, no longer contributing to operating profit, to have capital recycled sooner. This will be important for Stockland, in particular. The broker observes a relatively ambitious target to remove over $500m of the $570m in impaired inventory by the end of FY15. A better housing market may allow for greater demand for undeveloped sites from other developers. Supporting this observation, current land banks are well above what would be needed to support earnings over the next five years.

With developers no longer being compensated for these large land banks with consistent increases in land prices each year – as was the case prior to the GFC – Merrills believes the developers can reduce their land banks to 5-10 years of sales without putting future earnings at risk.

On a Buy/Hold/Sell or equivalent basis, the FNArena broker database rates Australand 2/3/2, Stockland 4/2/0, Lend Lease 7/1/0, Mirvac 2/5/0 and Peet 4/0/0.
 

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