2007's Top Picks: U.S. Real Estate

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Homebuilders will benefit from stability, analysts say, while REITs could finally begin to lose momentum

by Maya Roney
SPECIAL REPORT
BusinessWeek.com

Expect a changed landscape by the end of 2007 as the real estate market turns on its head and its related stock sectors—homebuilders and real estate investment trusts (REITS)—hit major peaks and valleys.

Homebuilder stocks, down considerably since hitting highs in the second half of 2005, stand to benefit in the long term from a more stable housing market. On the flip side, returns on REITs, which focus on large-scale commercial projects, may contract after shooting up more than 35% in 2006, compared with a 16% increase in the Standard & Poor's 500-stock index.

Analysts continue to debate the timing of a housing bottom, but recent statistics point to a revival in the not-so-distant future. Existing home sales edged up 0.5% in October and 0.6% November—trivial increases, especially given the wide margin of error, but increases nonetheless after months of decline. Housing starts rose 6.7% in November and 4.5% in December, after plummeting 14.6% in October to the lowest level in six years.

Sentiment measures may also point to better times ahead for homebuilders. Builder confidence increased in January, according to the National Association of Homebuilders/Wells Fargo Housing Market Index, which rose to 35 in the month, from 33 in December. The index is derived from a monthly survey that gauges builder perceptions of current and future home sales, with a score over 50 indicating that more builders view sales conditions as good than poor.

Meanwhile, increasing merger-and-acquisition activity in the commercial real estate segment demonstrates the continued appeal of office and retail properties. In November, private equity firm Blackstone Group announced it would purchase Equity Office Properties Trust (EOP), the nation's largest publicly owned office building manager, for a record-breaking $36 billion. Shopping-mall operator Mills (MLS) put itself on the selling block this month and is now juggling several billion-dollar offers.

As part of BusinessWeek.com's special report on analysts' top stock picks for 2007, we picked the brains of Wall Street pros for the most attractive opportunities in the sector.

Homebuilders

While the downturn may not yet be over for the housing market, a brighter future is in sight. So it may be time to get into stocks of homebuilders offering entry-level product before everyone else catches on.

"This year, we favor companies with exposure to the entry-level price point, as we expect demand for lower-priced homes to improve as affordability rises," says UBS Investment Research (UBS) analyst Margaret Whelan. She blames the correction primarily on constrained affordability, which fell to a 15-year low in the wake of rapid home price appreciation.

After earnings per share posted compound annual growth of 37% in the five years ended in 2005, homebuilders should see declines of 31% in 2006 and 51% in 2007, Whelan estimates. However, the analyst expects demand and prices to improve toward the end of 2007 as cancellation rates return to a more normal level and inventory is absorbed.

Whelan's top picks in the sector include:

KB Home The analyst is confident that the Los-Angeles homebuilder's KB Home Studios, a unique product offering that allows buyers to customize their homes, will drive market share gains once demand normalizes. Whelan believes management is "navigating the [housing] downturn admirably" by focusing on profitability, cutting back land purchases, maintaining a conservative balance sheet, and repurchasing shares. KB Home (KBH) has the same share count today that it had in 1988 despite a fourfold increase in profit.

Meritage Whelan predicts small-cap Meritage (MTH) could see up to 35% upside to her $58 target price in 2007, the highest potential increase in her coverage.

"Despite Meritage's exposure to many of the markets that have been most impacted by the current downturn, we believe that the company's disciplined operating strategy will drive peer-relative outperformance next year," she says. Once demand normalizes, she expects the company to have "ample" free cash to pursue market share gains.

Pulte Homes Michigan-based Pulte Homes' (PHM) exposure to the retirement communities segment, which represented almost 40% of sales in 2005, should contribute to better-than-expected stock performance once demand stabilizes, Whelan says. In addition, she believes Pulte's focus on balance-sheet flexibility leaves the company well positioned to take advantage of acquisition opportunities after the market improves.

REITs

While the housing downturn took center stage in 2006, the REIT industry continued to boom, beating the broad stock market for the seventh year in a row. This year, however, overall returns will likely fall within a more modest –10% to +10% range, according to Citigroup (C) senior analyst Jonathan Litt.

"We believe the point at which multiples will begin to contract is getting closer," he says, comparing the rapid expansion in REIT valuations to the tech market bubble earlier this decade. Litt recommends blue-chip REITs, whose strong fundamentals make them the most likely to outperform the market regardless of valuations. REITs' typically rich dividend yields, which can run as high as 9%, may also compensate for tempered growth this year.

Litt's top choices for 2007:

Alexandria Real Estate Equities The office and laboratory space manager—one of only two buy-rated stocks in Citigroup's 68-company REIT coverage universe—is currently trading in line with REITs overall and at a discount to the office sector. Adding to the stock's appeal is its growing dividend, which was raised 3% in December, to 74 cents a share. Litt expects Alexandria (ARE) stock to generate 7% to 9% growth this year. "Given its large non-income-producing asset pool, the visibility on future growth seems more certain," he says.

Equity Residential Litt recently raised his rating on the apartment REIT to buy from hold, making Equity Residential (EQR) the only other buy rating in the universe of stocks he covers. He expects to see earnings growth in 2007 as the REIT puts its condo and corporate housing businesses behind it. The Chicago company's bottom line should also benefit from its newly repositioned portfolio on both the East and West coasts, the analyst says. Equity Residential recently boosted its dividend by 4.5%, to 3.5%, or $1.85 per share.