All About Location for Home Builder Stocks: Pros
The recent spike in Treasury yields has sent home builder stocks tumbling as investors worry about what higher mortgage rates may mean for the housing recovery.
Higher rates may not kill the recovery, analysts say, though smart stock-picking will become more vital in the second half.
"If you think about what goes behind affordability, which is what we're all focused on now, it's mortgage rates, it's income, and it's house prices," Megan McGrath of MKM Partners told CNBC last week. "House prices are going up, mortgage rates are going up, so we need incomes to start going up, and that's what we'll be keeping an eye on over the next couple months."
Interest rates may also spur those homebuyers who had been sitting on the fence to jump into the market to lock in a low rate before they go. But along with rates, how much house and the neighborhood they can afford will rise, too, said Brad Hunter of MetroStudy.
"A move from 3.5 percent mortgage rates to 6 percent is a 34 percent increase in the monthly payment," Hunter told CNBC.
That doesn't necessarily mean that home builder stocks can't keep advancing; it just means that investors will have to be more selective.
"We expect little disruption in the mortgage market near-term, with mortgage rates trending upward while remaining at very low [historical] levels," Goldman Sachs analysts wrote in a research note. "There is recent apprehension among market participants about a rise in rates derailing the recovery. However, we expect a very mild effect overall and expect higher rates to be accompanied by an improving economy."
Resuming coverage on home builders Monday, Goldman Sachs sees only modest upside for the overall group in the next 12 months but a wide difference between individual stocks.
The Goldman analysts recommend investors do three things: focus on the geographic markets with the best growth potential, concentrate on higher-end home builders, and sell companies with weak geographic exposure and that cater to the low end of the market.
"We think that, as the market continues to normalize, stock performance will increasingly depend on exposure to individual markets which have the best growth," the analysts wrote. That leads them to prefer Ryland and Meritage, given their presence in the hotter markets of Charlotte and Orlando, respectively.
Goldman's $51 price target on Ryland implies a potential 32 percent upside, while the $53 price target on Meritage implies a more modest 23 percent upside from current levels.
The broker also likes Toll Brothers, saying the company is "ideally positioned in the luxury home building market."
But it may not be a straight move higher after home builder stocks, represented by the S&P Homebuilders ETF, fell 11.5 percent in the past month and as the industry moves into what is considered a seasonally slow period. That could mean more volatility as investors weigh interest rate moves against industry and company fundamentals.
(Read More: Housing Stocks Post Worst Week in a Year)
"The good news is when we get to back of the year, the stocks are going to do well," UBS analyst David Goldberg told CNBC last week. "Buy the dips here, and wait for opportunities to take advantage of the move up in margins and profits as we go forward."
Meanwhile, Goldman has a sell rating on Pulte because of its weaker geographic markets and its strategy to consolidate instead of grow over the next few years.