By Danielle Levy of Citywire

As the government prepares to unveil its new housing strategy tomorrow, focus has been thrust onto house builder stocks.

But while stocks in the sector now look unlikely to receive a boost from an opening up of the green belt to building, some investors are paying more attention to the strong yields they boast, after heavy share price falls following the Brexit vote.

The UK’s vote in favour of leaving the European Union sparked significant share price falls across house builders, as investors feared the worst in the immediate aftermath.

Fortunately, the picture today looks more positive. Economic growth has proved robust, unemployment remains low and there is strong demand for housing.

House builders’ share prices have recovered but are still some way off the levels seen before the ‘Brexit’ vote. Dividend yields also look attractive, with Taylor Wimpey (TW) on a trailing yield of 6.8%. This measures dividend payments over the last 12 months relative to the share price. Berkeley’s (BKGH) trailing yield is similarly high at 6.7%, Galliford Try (GFRD) is on 6%, while Persimmon (PSN) is on 5.6%.

However, high dividend yields can also reflect share price falls, indicating that investors feel unsure about future earnings – and potentially a company’s ability to pay its dividend.

So how safe are house builders’ dividends?

It is worth noting that the house builders’ trailing yields often include special dividends. This happens when a company has decided to return cash to shareholders as a one-off payment. However, investors can’t rely on these payments being made in the future. This is prudent on the part of the house builder, given their economic sensitivity or ‘cyclicality’.

Wary of downturn

Simon Brazier, manager of the Investec UK Alpha fund, sums up the situation well.

‘The fundamental issue with the housing sector is that it is highly cyclical, which means that when there is a downturn, cash flow disappears. This is why they are paying most of their dividends as special dividends, which is sensible because they are not saying to the market that the total dividend they are paying this year is sustainable for future years.’

For example, when Taylor Wimpey’s special dividends are stripped out, its trailing dividend yield over the past financial year was just under 1%.

Over the next two to three years, Brazier expects that house builders’ dividends should be stable – as long as the UK consumer remains healthy. The fund manager adds that over the past two years house builders have continued to grow their profits and cash flows, maintaining strong balance sheets.

However, Brazier does not view the sector as a screaming buy right now. He took the decision to sell out of house builders in 2015 because he believed valuations were starting to look expensive. He had initially bought into the sector in 2010 when prices were depressed.

‘Now, these stocks are trading on more realistic valuations of 1.5 times book value typically for the sector, which would suggest they are able to continue to deliver decent returns from here.

‘Having said that, let’s not forget this is a very cyclical sector. Hence, if we were to see a downturn in housing markets, it is not so much about prices, it is about volumes and transactions. If the consumer says they are not going to buy, their cash flow dries up quickly. It’s not like a consumer staple company like Reckitt Benckiser (RB), which continues to sell Nurofen, Cillit Bang and E45 cream during a downturn,’ he said.

While he notes that some value has started to emerge in consumer cyclical stocks for the first time in a while, he prefers wholesaler Booker (BOK), which is soon to be acquired by Tesco (TSCO) and high street retailer Next (NXT).

Brazier is seeking exposure to the construction sector but not through house builders. Here, he owns carpet company Headlam (HEAD) and Breedon (BREE), which provides construction materials.

Housing cycle has further to go

Job Curtis, manager of the City of London (CTY) investment trust, believes current house builder share prices could present buying opportunities for investors.

‘I would be happy to buy them [house builders]. Valuations look attractive in the context of the market. You are getting a pretty attractive yield from Taylor Wimpey and Persimmon at the moment,’ he said.

The fund manager holds these two companies alongside Berkeley Group in the trust. He added to positions during the summer, as he believed share prices looked low.

Curtis doesn’t expect to see the dividends of these three companies come under pressure over the next two to three years. He points to Taylor Wimpey’s cash pile of £365 million and Persimmon’s net cash of £700 million, which are supportive for balance sheets and future dividend payments.

‘I think there is a lot of latent demand for houses. We have full employment, population growth and a lot of “generation rent” who want to own. The backdrop is pretty good and during the recession a lot of smaller house builders got taken out,’ he added.

Rising unemployment and higher interest rates represent the two biggest threats to the sector. However, he is not seeing evidence of either in the UK just yet.

He says investors must be aware that house builders are unable to offer the same stability in their income streams as consumer staples and utilities, for example. However, the sector still offers opportunities for income-hungry investors.

‘Personally my view is the housing cycle will be extended. There is a huge imperative politically and socially to start raising the level of home ownership in this country again. And I think house builders are well placed to deliver that,’ he added.

This article is independently written by Citywire and not subject to editorial oversight by Blackrock