Summary: The housing construction cycle has reached elevated levels, with dwelling approvals climbing above the long-term average as well as most historical cyclical highs. But while it has been in an upwards trajectory since 2012, we aren’t calling a peak nor forecasting a crash. Rather, the later stages of the cycle should have longer durations than previous cycles due to accommodative monetary policy and the increase in the lag time between approvals, commencements and completions of buildings.
Key take-out: Brickworks is our preferred exposure within the mid-cycle housing construction cycle. For the late cycle GWA Group also screens as an interesting, though we are yet to do sufficient analysis to make a formal recommendation.
Key beneficiaries: General investors. Category: Shares.
It would seem difficult to get through the weekend papers at the moment without reading multiple stories regarding the hot property market.
Most of the commentary is about house pricing, particularly in Sydney and Melbourne.
Today we thought it worth considering the housing construction cycle, which is also at elevated levels, and explore whether there are any sensible ways to gain exposure via the equity market.
Housing construction cycle – a review of the data
Australian dwelling approvals, including both apartments and single-family homes, are currently annualising in excess of 200,000 new homes per annum.
As you can see below this is the highest level since the ABS commenced producing this data series in the early 70s.
This run rate is significantly above the long-term average of 145,000-150,000 as well as above most historical cyclical highs.
Digging a little deeper will show that the composition of this growth is largely biased towards multi-dwelling construction – or apartments and townhouses.
Approvals for single-family dwellings have increased in the last two years but are not materially different from long term average levels. In contrast, approvals for multi-dwelling construction have increased materially and are at nearly twice the long-term average. Not-surprisingly the activity is biased towards Melbourne and Sydney.
It is important to be aware of the composition of the activity as well as the regional skews as the businesses (and stocks) that are exposed to overall cycle have quite distinct compositions themselves.
One further observation, which we think is often overlooked, is that the lag between building approvals and building commencements/starts has materially increased this cycle.
More specifically, where a building approval has historically taken 3-6 months to turn into a commencement, this is now, on average, closer to 12 months.
Anecdotally (and intuitively) these lags appear to be driven by an increased contribution by multi-residential construction (which is usually a longer construction process) and strength in overall activity levels in some regions leading to capacity constraints.
In any case we believe the data has some important implications.
- With monetary policy likely to remain accommodative for some time conditions remain supportive for elevated housing construction activity. While some risk may exist in the level of apartment construction, we see further upside in single-family dwelling activity, which is only at long-term average levels.
- The increase in lag between approval/commencement/completion should increase the duration of this cycle and should underpin for some time the earnings of companies exposed to the late stages of the cycle.
Investing along the construction cycle – prefer mid to late cycle businesses
The housing construction cycle has been on an upwards trajectory since early 2012 following the commencement of the most recent interest rate easing cycle which commenced in late 2011.
While we are not calling a peak nor forecasting a crash it appears clear that we are entering the later stages of the cycle. However, it appears that the later stages may have longer duration than previous cycles.
In our view, the data remains relatively supportive and with the lags between approvals and commencements increasing we expect businesses exposed to the later stages of the cycle will continue to generate robust earnings for some time.
We outline below a brief summary of the valuation metrics of a range of companies exposed to different stages of the cycle. Clearly, some companies have some specific nuances such as cost-out programs (Boral) and unrelated business exposures (CSR’s aluminum business).
We make the following key observations regarding the analysis outlined above:
- Even if the RBA cuts interest rates further tomorrow we are likely approaching the later stages of the housing construction cycle.
- ABS data suggests that the lag between approval and commencement has increased which will likely prolong the duration of this cycle. This should underpin both mid and late cycle business earnings.
- Companies exposed to the early stages of the cycle may appear cheap, however, they may be trading on peak cycle earnings.
- We would caution paying above average valuations for early and mid-cycle companies trading on near peak cycle earnings (even if those earnings may be sustained for some time).
- Companies exposed to the later stages of the housing construction cycle on sensible valuations appear to be the most attractive exposure to this theme.
Brickworks is our preferred mid cycle exposure. GWA screens as interesting.
We have written at length about Brickworks (BKW) so far this year. You can read about it here from April and here from January. With supportive economic conditions, a high relative exposure single family dwelling (when compared to apartments) and an undemanding valuation, this company remains our preferred mid cycle housing construction exposure.
While we are yet to do sufficient detailed due diligence to make a formal recommendation, GWA Group (GWA) also screens as an interesting late cycle exposure.
GWA is Australia’s largest supplier of home construction fitting and fixtures, primarily focused in bathrooms and kitchens. Its key brands include Caroma, Dorf and Fowler.
The company is currently rationalising its non-core assets, having sold its Dux and Brivis businesses and recently announcing its intention to divest the Gliderol garage door business.
As a result of this restructuring the company has limited debt, recently announced an $88m capital return and would appear likely to recommence paying a dividend in FY16.
Furthermore, the divestiture and sale of non-core, poor performing assets should improve returns and the company’s cash generative ability.
With interest rates likely to remain subdued for some time, conditions appear likely to remain supportive of housing construction for a while yet. This is particularly the case when you consider that lag between housing approvals and housing commencement/completions (i.e. when GWA sells its products) has increased in recent years.
It would appear that at 15 times next year’s earnings, limited upside is priced in for a return to dividend, sustained earnings and improved return on invested capital.