Vistry: A Spirit Of Partnership

While researching Techtronics, the Hong Kong-listed owner of the Ryobi and Milwaukee brands of cordless power tools, I naturally looked at the American residential construction market to understand demand. Seeing how lucrative homebuilding has been in America made me curious, and it was only a short intellectual hop across the Atlantic to look at Britain.

Interestingly, both housing markets suffer from the same chronic shortage of new homes, contributing to an undesirably high appreciation of home prices and rents. The common factors are regulation, rising costs and a financial conservatism borne out of the Global Financial Crisis, during which many overstretched homebuilders found themselves on the verge of failure.

This bust laid the seeds of a subsequent boom: with growing demand and constrained supply, the equity of American and British homebuilders has performed exceptionally well over the last fifteen years.

Britain’s Housing Crisis

This has not been good for society, however: Britain has a housing crisis. Affordability in its major cities has deteriorated; over one million households are on waiting lists for subsidised housing; one in ten people live in sub-standard housing; and the number of adults living together has risen as young adults defer moving out from home.

To address the issue, the British government set a target in 2017 to build 300,000 homes a year in England alone (i.e. not including Scotland, Wales or Northern Ireland). An independent think tank, The Centre For Cities, argues in a paper published this year that this target is not ambitious enough: 442,000 homes must be built each year to close the gap within twenty-five years, or 654,000 per year to close it within ten.

As it stands, just 188,560 homes were built in the whole United Kingdom in the twelve months ending June 30, 2023. There is a long way to go.

Planning regulation appears to be the critical impediment. The 1947 Town & Country Planning Act permitted ‘green belts’ around major urban centres in which development is forbidden. The Act also devolved powers to local authorities to consent to development on a discretionary case-by-case basis. “No” became the default answer rather than “yes”, and Britain built far fewer homes per capita in the post-WWII era than its European peers.

NIMBYs have stymied recent attempts to reform the planning process. Conservative-party Prime Minister Rishi Sunak abandoned his plans in the face of opposition from sixty of his backbench MPs. He now promises not to “concrete over the countryside” (unlike his Labour Party opponents, apparently). Ironically, a core tenet of the new Levelling Up & Regeneration Bill, meant to address the Housing Crisis, is to devolve more power to local authorities.

The cost and financial risk of land banking is another impediment since the UK does not have the same land optioning market as America. After acquiring land, homebuilders must then navigate the lengthy and expensive process to obtain consent to build. The costs, both in terms of time and money, are prohibitive, which has led the industry to consolidate around a handful of large players.

However, there is an inherent conflict of interest between the homebuilders’ business model and the government’s goal to increase supply, as articulated in a paper published in 2017 by a committee of the British Parliament:

The high volume homebuilders dominate the market and are therefore able to shape how it operates. Having purchased land at a given price and devised a scheme that will allow them to recoup their investment and deliver a profit, they will not risk over-saturating a local market to the extent that house prices will fall and their profits decrease. This is rational commercial behaviour and a sound business model. But it is not one that is in the country’s best interests.
Our concern is that when developers say they build to meet demand, what they mean is that they build to meet demand at a certain price. It is generally accepted that developers seek a profit margin of around 20 per cent of their investment, and so they build in a way that delivers this. We do not blame them for doing so, but note that the structure of the industry does not encourage them to deliver the increased supply of housing that is needed. In order to boost supply, a perspective that moves beyond the short to medium term is necessary.

The committee went on to conclude (emphasis mine):

We do not believe that developers intentionally inflate prices—but they reduce risk by building to demand at current prices, and there is insufficient incentive for them to build any quicker, and considerable incentives for them to ensure that local prices do not fall. We encourage the Government to consider how it can influence the financial model of the sector and encourage developers to take a longer-term perspective and a greater stake in civic homebuilding.

The Partnership Model

Enter Vistry and the Partnership model, which offers a win-win-win outcome for the homebuilder, housing providers and households.

Let me put it in context.

At one end of the spectrum, imagine a homebuilder that builds and sells all its stock itself. It runs a cashflow deficit from when land is purchased until a home is sold, which might take seven years or more. It takes all the risks in between, including obtaining consent to build; obtaining financing and meeting interest payments; designing an attractive product and delivering it on budget; and, finally, making a sale at a price that earns an acceptable return. This is a balance sheet-heavy model exposed to many cyclical factors.

At the other end of the spectrum, imagine a construction company that builds homes for someone else. It is responsible for delivering those homes on time and at cost, but not for how they are designed or for how much they are sold. It is not responsible for the development’s upfront investment and should avoid any cashflow deficit if it manages its working capital well. This is a balance sheet-light model, though one which usually operates on much thinner margins due to lower barriers to entry. It remains cyclical and at risk of cost blowouts.

The Partnership model lies in between. It’s straightforward: partners pre-purchase the majority of homes in a development in exchange for a volume discount. What the homebuilder loses on margins, it makes up for with a higher return on capital (since it is paid upfront and in stages) and greater certainty (by locking in a sale price). The homebuilder’s risk sits between the traditional model (it must still sell the homes it does not pre-sell) and a construction company’s (it must deliver the partnership development on time and at cost).

Who are the partners on the other end of this trade? Fully-public Local Authorities, quasi-private Housing Associations and fully-private financial investors.

Why should they be interested? To deliver a large supply of homes quicker than homebuilders would themselves, while managing their own risk by ensuring the homebuilder keeps skin in the game.

What incentivises the homebuilder? It must build the development to a high enough standard to profitably sell the homes it does not pre-sell, on which it takes risk. And given the ‘potpourri’ nature of Britain’s mixed tenure development (more on this later), that means ensuring a high standard overall.

The matrix below comes from a roundtable organised by British law firm Trowers and Hamlin, explaining the various benefits to each party.

Generation rent

It’s important to emphasise that under the Partnership model, the partners retain ownership of the homes they pre-purchase. This is Britain’s solution to its housing crisis: rather than making homes more affordable to buy, it is making more homes to rent.

The chart below from a paper by the Brookings Institute illustrates this trend over the long course of history, showing how the proportion of private rentals began rising from its nadir after changes to the law made tenancy more favourable to landlords (1988) and ‘buy to let’ mortgages made investment properties a feasible option for individuals (1996). Per the most recent English Housing Survey, prepared by the British government in 2022, 64% of British homes are now in private ownership, 19% are privately owned rentals and 17% are publicly owned rentals.

The British press call this “Generation Rent”, defined by economicshelp.org as:

young adults (18-40) who have been priced out of the housing market – unable to buy and having to pay a high percentage of income on rent. As well as an expensive housing market, generation rent faces financial difficulties from high living costs, student loans and low wage growth. It is related to the concept of ENDIES – Employed with no disposable income. The problem of generation rent is mostly related to a broken housing market, where house prices have risen faster than inflation for a number of decades.

As you can see in the chart below, for a first home buyer, the affordability gap between renting and buying is at its widest in a decade.

BUILD-TO-RENT

The ‘build to rent’ (“BTR”) model takes this trend to an industrial level. Rather than buying existing individual homes to rent as Blackstone did in America, investors in Britain are now commissioning large-scale developments for the express purpose of renting them. According to Savills, the real estate advisory, as of 1Q23, some 88,100 such BTR homes are already in the market, with another 53,487 more under construction and 111,815 under planning.

Savills reported in its 1Q23 BTR Update:

The second quarter of 2023 saw a marked improvement in the amount of capital invested into UK Build to Rent (BtR). This resulted in the highest Q2 on record, at £1.26bn.
8,300 homes have been funded since the start of the year, but this will not shift the dial on the UK’s supply-demand imbalance. With fewer homes to rent and record private sector wage growth, rents grew by 10.4% in the year to May 2023.
Meanwhile, interest rate rises have reduced the profits of Buy-to-Let landlords, and future growth is unlikely to come via this route.
Eyes have turned to BtR to plug the supply gap, and the sector is already taking an increasing share of new housing delivery. BtR still makes up less than 1% of privately rented homes, but we expect this to grow as new entrants emerge.

Why are financial investors interested in BTR? Simple: it offers a higher yield than they can get elsewhere. (At least, it used to. I’ll come back to this later). And they can put a lot of capital to work. For example, as of 1H23, just under a third of British insurer Legal & General’s GBP 8 billion investment portfolio was invested in residential real estate.

BTR projects were initially centred around London but are increasingly launching around Britain’s other major metropolitan areas. In the map below, green dots represent completed projects, blue dots are projects under construction and yellow dots are projects under planning. This suggests that the model is getting more traction with greater proof of concept.

CASE STUDY: THATTO HEATH

Thatto Heath is an excellent example of Vistry’s Partnership developments. It is what the British call a ‘mixed tenure’ development, with tenure referring to the liability side of the homes’ balance sheet - who has equity, in what proportions and under what conditions; as well as how rents are set and to whom the home is rented.

To avoid ghettoisation and stigma, privately owned and rented homes in mixed tenure developments sit side by side and are designed to be indistinguishable. Vistry is, therefore, incentivised to ensure the overall character of the development so that it can profitably sell the homes on which it takes risk. In practice, the homes sold to private buyers will typically be a little larger or have more garden space or a nicer view.

The press release below, from 2022, explains the key terms (emphasis mine):

Tony McDonough reports Housebuilder Vistry Partnerships has submitted plans to build 164 new homes in Thatto Heath in St Helens. Vistry has exchanged contracts on the land owned by St Helens Council.
Under the proposals, 81 homes will be sold on the open market by Vistry under its Linden Homes brand. Housing association Torus will take on the additional 83 homes to offer affordable accommodation. Vistry has also committed to delivering 25% of the homes as accessible for disabled people. Vistry has previously worked on a scheme in Runcorn.
This previously developed site is located next to the railway station in Thatto Heath, south of St Helens town centre. It has been earmarked for redevelopment by the local authority for some time.
Vistry has secured funding from the Liverpool City Region Metro Mayor Steve Rotheram’s Brownfield Land Fund. This has allowed remediation work to take place. Subject to planning permission, works are due to start on site by the end of the year, with the development completed in 2026.
Ian Hilliker, managing director of Vistry Partnerships North West, said: “Using our regeneration and partnerships expertise, I’m delighted that we’ve been able to work collaboratively with the local authority and Torus to develop these high-quality plans for Thatto Heath.
“The highly accessible and prominent site can play an important regeneration role in the wider community, delivering a range of mixed-tenure homes that will give local people a great chance to live here.”

To recap:

The local authority contributed land for the development, a brownfield site;
Additional funding was secured from the Liverpool City Regional government;
Of 164 new homes, Vistry will take risk to sell 81 on the open market to private buyers; and
The remaining 83 new homes will go to a local housing association to offer affordable accommodation.

VISTRY GOES ALL-IN

Vistry announced at its 1H23 results briefing in September 2023 that it will go all-in on Partnerships, folding its landbank into the endeavour and aiming to return GBP 1 billion surplus capital over 2024-2026.

When complete, Vistry will target 40% returns on capital employed (a metric that excludes goodwill and other provisions) and 5-6% p.a. revenue growth. The goal is to reach GBP 800 million in adjusted operating profit by 2028, have no net debt (before land creditors), and return at least half of earnings each year via buybacks and dividends.

This was not an overnight development. Vistry is a company with more than a hundred years’ of history, and was transformed over the last twenty-five years through a series of corporate actions. Its CEO, Greg Fitzgerald, has played a prominent role throughout.

In 1998, Galliford, a construction company with ambitions to boost its homebuilding division, acquired Midas Homes, a small homebuilder led by Fitzgerald.
In 2000, Galliford merged with Try (a construction company with a small sideline in homebuilding) to form Galliford Try.
In 2005, Fitzgerald became CEO of Galliford Try. He acquired a string of construction companies and homebuilders to boost the company’s scale and led it through the Global Financial Crisis with mixed results. He retired in 2015.
In 2018 and 2019, two major cost overruns cast doubt on Galliford Try’s solvency. To raise capital, it sold its homebuilding division to Bovis, another homebuilder. Bovis’ CEO was none other than Fitzgerald, who had come out of retirement for the role. The combination was renamed Vistry, a portmanteau of its predecessors’ names.
In 2019, before acquiring Galliford Try’s homebuilding division, Fitzgerald formed a new division at Bovis to pursue Partnership opportunities. By 2021, Partnerships had grown to 32% of Vistry’s revenue.
In 2022, Vistry acquired Countryside, a homebuilder whose development business was struggling but whose Partnership business was thriving. Under pressure from American hedge fund Browning West, Countryside had earlier announced in 2021 that it would go all-in on Partnerships.
However, in the wake of a boardroom fight and poor results, then two failed privatisation attempts by Inclusive Capital - another American hedge fund - Browning West agitated for Countryside to look for a buyer and eventually supported Vistry’s (lowball) offer.

Vistry’s acquisition of Countryside can be seen as accelerating what Fitzgerald started at Bovis in 2019. However, the details of its strategic transformation are almost identical to what Countryside agreed with its American shareholders, just on a larger scale.

CAN VISTRY DELIVER?

The opportunity is there. The question is, can Vistry deliver?

The Partnership model’s lower margins mean that Vistry must deliver c. 24,000 homes p.a. to reach its 2028 GBP 800 million adjusted operating income target. Sustained output from a single developer at this level would be unprecedented in British history.

Vistry completed 6,050 homes in 1H23 (the first full period after the Countryside acquisition). Management explained that 1H23 NPBT of GBP 174 million was just under 40% of their full-year guidance, reflecting the usual seasonality of completions. If we use this 40:60 split to annualise, we can perhaps expect Vistry to complete 15,125 homes this year. Reaching its 2028 target will, therefore, require a ~60% increase in per annum completions.

It will require a radically different organisation, more industrial in nature than anything seen to date. Land will be turned over far faster than previously, as Greg Fitzgerald explained to an analyst:

Gone are the days now where we've got a couple of sites, which are 4,000 units. We would have been on those for 15, 20 years because your build rate will match how quickly you can sell houses on that particular site. Now we're going to be asking a different question, how quickly can we build 4,000 units? Having presales 65% of them, and that's an entirely different question, and we'll get through that very, very quickly in maybe 4 to 5 years. So we will be burning through the land bank at a very, very quick period.

Vistry’s landbank currently has 46,378 plots already designated for Partnership and 30,200 plots designated for homebuilding, which will be re-designated. In addition, it has 66,189 plots of ‘strategic land’ which have not yet received consent for building. In total, these could deliver just under six years’ worth of its target output.

How will Vistry compete against other homebuilders when acquiring land? At face value, lower margins mean it cannot afford to pay as much. But this should be more than offset by faster asset turnover, which will raise the IRR of any investment by shortening the payback period.

In my conversations with Vistry’s IR, they emphasised that scale will necessitate greater standardisation. Countryside had begun to integrate vertically with three factories to manufacture up to 5,000 wood-frame homes, and Vistry will continue this project. Vistry will also demand better prices from its sub-contractors in exchange for more business. It has already sent out a letter this month asking for a 10% discount.

What about competition? Management has signalled that other homebuilders are tendering for Partnership projects, but they characterise this as ‘late cycle’ behaviour, which will end once the housing market stabilises (more on this later). The institutional imperative may be the largest barrier: I don’t believe Vistry’s peers’ shareholders will allow them to “sacrifice their margins”. Nor do I believe Vistry’s peers will risk impairing their landbanks given the importance British investors place on net asset value (as opposed to cashflow).

This is all conjecture, however. We will receive more data points in the months and years to come.

MIND the Cycle

Having introduced the long-term opportunity, it’s time to acknowledge the elephant in the room: Britain is on the cusp of a nasty housing downturn. Inflation is rampant and has not come down in 2023. As I write, Truflation reports its index rose 7.39% y-o-y in Britain vs. 2.25% in the US. Some reasons are cyclical (Britain imports much of its energy and food), and some are structural (there has been a labour shortage since Brexit).

Yields on long-term British government bonds have spiked, as have mortgage rates. Because Britain does not have a market for long-term fixed-rate mortgages, home prices will not be shielded by owners ‘locked in place’ by low rates. And home owners will feel the pinch when they re-finance their two- and five-year fixed-rate mortgages, the most common tenors in Britain.

Homebuilders have responded to date by reducing volumes to protect prices. Cynically, this is a clever way to avoid marking their land banks to market. I like this illustration of price discrimination from Praetorian Capital’s analysis of the US housing market:

I like to keep concepts simple around here. Let’s do a thought experiment. Say there are 1000 buyers who can afford a home when a 30-year mortgage is at 3%. Say there are 800 buyers who can afford it at 4% and 600 who can afford it at 5%. Now, realize that none of this matters; because there are only 100 homes to fight for. This sums up the US housing market today.

This could go on for some time. In contrast to the Global Financial Crisis, as a group, the British homebuilders enjoy net cash balance sheets and do not face any immediate pressure to liquidate assets. And as homebuilding slows, the housing crisis will only become more acute, setting the stage for a stronger recovery later.

Of course, it would only take one firm to step out of line and cut prices to bring the whole thing crashing down.

Vistry must execute its transformation against this difficult backdrop. It has two things going in its favour, however. First, most of its revenue already comes from the Partnership model, offering greater stability and certainty than its peers. Second, as it folds its landbank into new Partnership projects, it is effectively selling it in bulk at current prices. This will reduce its cyclical risk, both now and in the future.

In my opinion, the greatest uncertainty is whether the Partnership model remains an attractive and viable proposition for partners. Inflation, economic slowdown and higher interest rates are surely putting pressure on Local Authorities and Housing Associations. And financial investors must now weigh the risk against a much higher risk-free rate. The discounts achievable should offer some buffer, however. Vistry reported in its 1H23 results that its mixed tenure Partnership ASP was GBP253k, more than a third cheaper than its private sale ASP of GBP387k.

WRAPPING IT UP

I want to give the closing word to Jeffrey Ubben, formerly of ValueAct Capital and now co-founder of Inclusive Capital (“In-Cap”), the American hedge fund which tried to privatise Countryside. In-Cap rolled over its shares when Vistry acquired Countryside and has since become one of Vistry’s largest shareholders, with Ubben a Director on Vistry’s Board.

Ubben set out his vision for Countryside in a letter to shareholders he sent in 2022, and it is just as apt for Vistry today:

“Countryside looks to regenerate areas, and through its mixed-tenure approach supports communities, by developing and building affordable homes for rent and for sale next to higher priced private homes.
“In working with land owners, housing associations and government authorities, Countryside seeks to address an acute need for high quality affordable housing in the UK. We believe Countryside’s success is linked to this need and also will be the source of future growth.
“In-Cap was founded to support businesses which generate positive impact on the environment and society.
“We believe Countryside is meeting a critical societal need and as a holder of approximately 9% of the issued share capital of Countryside, In-Cap believes Countryside is best positioned to serve this role and to succeed as a private company under ownership of investors with a long-term investment approach.”

Disclosure: Longriver Investment Partners Limited manages the Longriver Partners Fund and separately managed accounts. These portfolios may hold or trade securities discussed in this article, and their holdings may change without notice.