Stocks to Watch if U.K. House Prices Do Crash

 | Jul 26, 2017 | 8:00 AM EDT
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With London property prices at 12 times average incomes and the U.K.'s departure from the European Union canceling investment plans and shifting jobs to the continent, British real estate is set to slow down.

If indeed Brexit does cause U.K. property prices to fall sharply, even by 50% in prime London areas as recent research by Societe Generale predicts, there is one obvious question: What should investors do?  

It's a difficult decision to make, because the Teflon-like asset class has weathered many crises before. Still, this time, prices are just too high. There are no more bargains.

For investors who want to be actively short British property, there are not many options. But staying away from the homebuilding sector would be a good idea.

The sector looks tempting, with a homebuilding index compiled by FactSet consisting of 15 U.K. homebuilders up almost 35% year to date.

It doesn't look too expensive, either. The index's trailing 12-month price-earnings ratio is at 9.6 versus 16.5 for the U.K. stock market as a whole, and it has a dividend yield of 5.4% compared with the market's 3.6%.

The top five components -- Persimmon (PSMMY) , Barratt Developments (BTDPF) , Taylor Wimpey (TWODF) , The Berkeley Group (BKGFY) and Bellway (which does not have a New York listing) -- have seen hefty share price rises, of between 25% and 45% this year.

The data above make it look like a good opportunity to go long homebuilders, rather than short them. But dig deeper and the flaws in their business models become obvious. Perhaps their biggest weakness is their reliance on government money.

The U.K. government has managed to prop up home prices by offering equity loans equal to 20% of the property's price outside London and 40% in London in order to help buyers who otherwise would struggle to put together a deposit.

This policy has spurred on homebuilding. Analysts have estimated that this program, called Help to Buy, accounts for approximately half of homebuilders' sales. For now, the government money keeps flowing, but what will happen when it dries up?

With the U.K. government facing a big Brexit bill and various other expenditures to compensate for the loss of European Union funds, it is possible that propping up house prices will slip lower on its list of priorities. Plus, the first Help to Buy loans will begin to require interest payments soon, after having been exempt for five years.

Investors definitely should keep an eye on homebuilders, but bear in mind that shorting them would be a dangerous business; the government always could decide to throw even more money at the housing sector.

Domestically oriented banks are another asset class to watch. The biggest mortgage lender is Lloyds Banking Group (LYG) . Royal Bank of Scotland (RBS) , Santander (SAN) and HSBC (HSBC) are also big players in this market. These banks, however, are well-capitalized and can withstand a house price fall.

More exposed to house price weakness are the so-called challenger banks, which have focused on niche sectors such as lending to buy-to-let landlords. One of them is Shawbrook, which trades in London under the symbol SHAW; another is Paragon Group, also trading in London only, under the symbol PAG. Data from the Financial Conduct Authority (FCA) does not show any short position in Shawbrook. On July 19, BlackRock Investment Management initiated a 0.7% net short position in Paragon.

Finally, there are the real estate investment trusts, REITs. A FactSet index of British REITs shows they are up almost 10% year to date, and look dear at a P/E ratio of 28.6. (The calculation uses funds from operations rather than earnings per share.)

The only REIT rated "buy", according to FactSet, is Secure Income REIT, which is listed only in London under the symbol SIR. Rated "overweight" are Land Securities Group (LSGOF) , British Land Company (BTLCY) , Hammerson (HMSNF) , SEGRO (SEGXF) , Safestore Holdings (only in London under SAFE) and Redefine International (RDPEF) . There are three REITs in the "hold" category: Intu Properties (CCRGF) , Great Portland Estates (GPEAF) and Shaftesbury plc. (SHABF) .

Investors would be wise to keep an eye on some of those REITs for potential ratings downgrades. 

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