Prudently Prune Homebuilders

In the long term, I believe the housing market will be healthy, but the boom has ended.

Shares in the homebuilders are close to the upper end of their trading ranges and are unlikely to break through to new highs soon. For investors who have ridden the stocks up, it's time for some prudent pruning.

Longer term, my model rates many of the homebuilders as strong buys. If you don't own them, you might want to buy the ones that are most undervalued on the list below. Demand from the baby boomers should increase as they relocate over the next 10 to 20 years to retirement areas, with Florida high on the list.

However, if we take a look at the case of Florida, we can see some of the risks for near-term weakness. According to the business magazine Florida Trend, homes in Miami and Tampa are overvalued by at least 20%. Developers must pay more for land, materials and labor and some projects are likely to be put on hold. Resources are needed for rebuilding in the areas hit by hurricanes Katrina and Wilma.

Rising interest rates will be a factor as well. About 46% of condo loans in Florida are adjustable-rate mortgages, and another 17% are interest-rate only loans. Only 37% are traditional fixed-rate loans. Also troubling for real estate and housing are the high levels of consumer debt, with banks tightening credit standards. Homeowners are facing higher property taxes, higher insurance rates and increased heating and cooling costs.

All of this will slow appreciation in home prices, but the downside should be limited to 20%. This is a plateau the boomers will take advantage of.

Recent Data and Earnings

MBA new mortgage applications fell 3% last week, but are up 0.6% year over year, which supports my steady outlook. Also supportive is the NAHB Homebuilders Index, which is unchanged in January at a reading of 57. Wall Street analysts are quite favorable towards the homebuilders, with median price targets well above where shares closed Wednesday. This makes this industry group vulnerable to downgrades, such as Banc of America's drop of Toll Brothers to sell from neutral Tuesday.