'Catastrophic' Possibility for Housing Recovery: Pro

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Buoyed by a nascent housing recovery, homebuilder stocks have risen dramatically this year — a positive trend that one analyst forecasts will continue, provided the mortgage interest rate deduction isn't eliminated, a move that he says could be "catastrophic."

"It's been a terrific year for the homebuilders," said Robert Wetenhall, an analyst at RBC Capital Markets. "We think we're still in the third inning – we're not in the seventh inning — both for the fundamentals and the stocks."

Despite a roughly 90-percent rise in homebuilder stocks year to date, RBC forecasts in a new research report that the sector will post another 30 percent of upside in the coming year.

Wetenhall expects tight inventory levels, low interest rates and a stable pricing environment to "drive demand very substantially next year." This should drive not only a 22 percent rise in new residential construction starts but also a recovery in repair and remodeling sales, according to the report.

"We see a number of stocks doing well who cater to that market next year like Lennar, like Pulte," he told CNBC's "Squawk on the Street." "Toll's going to do well and so will KB Home. We also see market share gains with the public builders, and our big call is that the sand states will show strength – Arizona, California, Nevada and Florida."

RBC Capital Markets analysts have "outperform" ratings on KB Home, Lennar and PulteGroup. D.R. Horton and Toll Brothers are rated "sector perform." Each of these companies' target prices reflect an upside of more than 25 percent.

"We think volume sales will definitely come in ahead of what the Street's looking for right now," he said. "We think pricing's going to be much firmer. We look for an upward move on Case-Shiller, and we think gross margin performance will also beat Street expectations."

But RCB's forecast of 950,000 housing starts is predicated on lawmaker's resolution of the fiscal cliff along with gross domestic product growth of 1.4 percent, a 7.8 percent unemployment rate and an average 10-year Treasury yield of 2.2 percent.

"We think there's enough access to credit right now," Wetenhall said. "The bigger threat is what happens in D.C. — the fiscal cliff story."

This outlook is subject to change if the mortgage interest deduction decreases or is eliminated. If taxes law changes make it more expensive to own a home, the housing recovery could be undermined, a worry that Wetenhall described as "our primary concern."

"If it's eliminated, that's catastrophic," he said. "There's no ifs, butts or ands around that.

—Written by CNBC.com's Katie Little. Follow her on Twitter @katie_little_

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Disclosure: The analyst(s) responsible for preparing this research report received compensation that is based upon various factors, including total revenues of the member companies of RBC Capital Markets and its affiliates, a portion of which are or have been generated by investment banking activities of the member companies of RBC Capital Markets and its affiliates.