The world suffered an unprecedented financial crisis in 2008. From all sectors, construction and house development experienced a bubble burst and many companies filed for bankruptcy. In Spain, house prices rose sixteenfold from 1998 and 2008. Many factors influenced house prices during those years, and some of the factors are the following:
- Ley del Suelo de 1998 law pursued the liberalization of land. The idea was simple: the more availability of houses, the cheaper the would get. Nevertheless, the land management was left to local governments and highly politicized savings banks.
- Overfinancing also played a fundamental role in the bubble creation process since banks used to grant loans and mortgages for the 100% of house market prices.
- Population growth.
- Sell of loans and mortgages to financial institutions (transferred risks).
Once subprime crisis erupted in the United States, house demand decreased more than 40%. In previous posts, we proved a useful framework that can help us in spotting investment opportunities, so I wanted to analyze house development sector to check if there is any undervaluated company.
As mentioned earlier, one of the key elements that pushed houses demand was credit accessibility. While it is true that it was easy for potential customers to get loans for the 100% of the house price, nowadays the situation is very different. As we can see in the following picture, financial institutions are lending up to 65% of total house cost, measeured by the loan to value ratio:
This fact means a barrier to house ownership since households needs to hoard, on average, the 45% of the house price in cash in order to get a mortgage. This means a strong saving effort from their part.
One factor that surely benefited house demand is the zero interest rate policy carried out by central banks. According to Instituto Nacional de Estadística, the average monthly mortgage payment is around €130. Assuming a modal salary of €17.000, it means the 10% of total salary and is a proportion that can be paid without major obstacles.
As a consequence of the bubble burst, many medium and small sized construction companies disappeared. While it is true that their activity has not stopped, it has not reached pre-crisis activity volumes. According to Ministerio de Fomento, there is a stock of around 460.000 new dwellings to be sold. This figure could imply that there is an overcapacity problem in the house development industry and may discourage a possible investment from a value investing point of view. Nevertheless, if we divide this stock by the total housing stock, we can see that it is not entirely true:
As we can see, regions like Murcia, Valencia, La Rioja and Canary Islands present a level of housing stock higher that the rest of the country. However, we can say that, in most of regions, there is no excess of supply.
Once that we have see that there is no overcapacity we can measure the current dwelling demand. According to Ministerio de Fomento, housing transactions have totaled more than 125.000 dwellings. This fact can be seen on the following graph:
The most significant component is second-hand house demand, accounting for more than 80% of total demand with 115.000 houses, while demand for new ones reached 12.000 transactions. I also wanted to contrast this figure with the amount of finished dwellings published by INE during the last six years:
As we can see in the previous chart, each year about 4.000 new houses are being finished and they represent about 40%of total demand. One of the consequences of undercapacity is that both house prices and rent start rising. In the following graph, it can be seen how house prices and rent have grown at 4% and 12%, respectively:
As it is seen on the previous chart, house stock is progressively declining. What is more, both rent and house prices are continuously rising since 2013. That increase can be seen by entrepreneurs as a signal of profitability. For those reasons some property promoter companies are briefly analyzed.
Construction companies: focus on Aedas, Insur, Neinor, Quabit and Metrovacesa.
I have chosen the following property promoter companies: Aedas, Insur, Neinor Homes, Metrovacesa and Quabit. They all have developed plots across the country except for Insur which is more focused in Andalusia and Madrid. Some of the selected companies have rental businesses, but have been deducted from operating metrics in order to get the real numbers from promotion business units.
Firstly, I wanted to calculate the EBITDA margin, a widely used proxy of operational performance. The results can be observed in the following line chart:
In the light of the results obtained, it seems like none of the companies, with the exception of Insur, are profitable. Nevertheless, in house development industry, inventory should be taken into account since is the balance sheet account that receives new investments in properties and lands. For that reason, I have also calculated the house developer gross margin to have a clearer picture.
As we can see in the previous graph, companies such as Metrovacesa and Insur have the highest gross margin followed by Aedas Homes. It means that this activity is, operationally speaking, profitable and they can continue developing houses. Cash is also important for investors. The more earnings are backed by free cash flow, the safer their dividends and the better their intrinsic value since we can see which proportion of profits are backed by cash or accruals. Thus, I have checked cash flow from operations minus interest + net debt repayment. The results are the following:
We can see how Insur is the only company that are making positive cash flows.
Valuation and financial leverage
Once that we have seen the most profitable companies from an operating perspective, I have measured the margin of safety that companies are offering.
Firstly, I have extracted the Gross Asset Value from financial reports. It is a standard measure across the industry and all of them pay for a third-party valuation in order to get the most realistic asset valuation. Secondly, I have deducted the net debt to get the Net Asset Value (NAV). After dividing NAV by outstanding shares, I have compared it to the shares prices in order to get the margin of safety. I have also added on a different axis, the loan to value. This metric measures the proportion of total investments that are backed by debt:
Regarding financial leverage, Metrovacesa and Aedas stand out for their low (even negative) loan to value ratio while Neinor, Insur and Quabit exceed the average value (blue line). Regarding margin of safety, it is noticeable how Insur and Metrovacesa offer the highest difference between NAV per share and stock prices, above the red line which indicates the average margin of safety.
As we have previously seen, the resulting stock of properties from the previous construction boom stage is being steadily absorbed. What is more, the construction pace does not seem excessive when compared to house demand.
Due to the fact that it is a sector that depends on debt, attention should be paid to interest rates evolution. It is true that Central Banks are announcing the end of quantitative easing. In fact, the FED has start rising the interest rates in United States, but an abrupt increase on the price of money may not happen in the foreseeable future.
As suggested by Benjamin Graham, an investor should not ignore the Balance sheet when valuing a stock. That is the reason I have used the Net Asset Value per share in order to reach an intrinsic value for those companies. With no attempt to issue an investment recommendation, I think that the industry offers a good discount to assets with a minimum of 20% margin of safety.