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With the U.S. housing market finally in full-on recovery mode, many investors are asking themselves whether it’s too late to join the party.Peter Power/The Globe and Mail

With the U.S. housing market finally in full-on recovery mode, many investors are asking themselves whether it's too late to join the party.

The bounce in U.S. real estate prices has been anticipated for so long, by so many, that the stock prices of home builders and related companies have been on a tear for more than a year. This week, U.S. home prices registered their first annualized double-digit gain in more than six years, but investors who want to act on the bullish news face the risk that the sector is already overvalued.

Consider this: During the housing collapse, prices tumbled on average more than 30 per cent, to levels not seen since before 2002. Today, U.S. house prices have recovered only to 2003 levels. But the stocks of U.S. home-builders are already nearing the highs that preceded the crash in 2007.

The Philadelphia Housing Sector Index, which tracks the shares of companies that build or sell residential housing, has shot up 54 per cent over the last 12 months. The price-to-earnings ratio for the group is now a lofty 29.8, nearly twice the level of the broader market.

Investors should be aware of the dangers involved in buying stocks at such pricey valuations. But money managers and analysts insist there is still money to be made. "I think it's not over at all," says Scott Baker, senior vice-president and portfolio manager at MacNicol & Associates Asset Management in Toronto. "But has the easy money been made? Yeah. Is it more risky than it was a year ago? Yeah."

Mr. Baker, who has been investing in U.S. real estate for several years, suggests that in general terms the price of real estate investments are about two-thirds fully recovered today. There may be years of growth in the housing market still, but investors are now paying a lot for growth. That applies both to shares of related companies and to real estate investment trusts. "As people look for income, anything that offers yield is already highly valued," Mr. Baker says.

In terms of new housing supply, there still appears plenty of room for rebound. The U.S. housing market should see at least a 22-per-cent increase in new home construction this year, to 950,000 "starts," says Robert Wetenhall, an analyst with RBC Dominion Securities Ltd. in New York. The long-term average, going back to 1991, is 1.4 million starts a year.

Mr. Wetenhall says there are still opportunities in home-builder stocks and the shares of building products companies. Among home-builders, his top pick is PulteGroup Inc., which he cites as a turnaround story with improving gross margins. He has a target price of $32 (U.S.) on the shares, which traded Friday at $21.72. The stock, which has more than doubled during the last 12 months, carries a price-to-earnings multiple of 28.

He also likes Lennar Corp. for its management team and what he calls "the best asset base" in the industry. He sees potential upside of almost 30 per cent based on a target price of $50. In addition, KB Home is well positioned in the California and Texas markets, Mr. Wetenhall says. He has a price target of $27 on the shares, which recently traded at $22.16.

Among the smaller building companies, M/I Homes Inc. has seen its valuation double in the last year. But Michael Rehaut and Jason Marcus, of JPMorgan, think the stock could climb another 35 per cent based on the amount of new home orders coming in. The shares may actually be facing a discount due to the company's exposure to the Midwest, the analysts say.

Among building materials stocks, Mr. Wetenhall likes Masco Corp., which sells cabinets, plumbing gear, roofing equipment and other products. The shares have been on a tear all year, but he thinks they could see another 25-per-cent gain given market conditions and management's efforts to control costs.

Other assets that investors can look at in this sector include REITs. The iShares Dow Jones US Real Estate (IYR) trust is the most liquid in its class, according to Morningstar. Almost 90 per cent of its holdings are equity REITs, which are firms that manage properties, collect rent and distribute most of their taxable income to shareholders.

To try to get a little more return than competitors, IYR also holds mortgage REITs. Mortgage REITs borrow money to buy mortgage-backed securities, with the expectation that these holdings will generate more income than the short-term borrowing costs. Mortgage REITs make up about 9 per cent of IYR's holdings. IYR has a yield of only 3.5 per cent, which is small by the standards of most Canadian REITs. But the price has appreciated by about 14 per cent over the last 12 months.

"Although there has been a strong rebound in the housing market, there are still a lot of pockets of investor opportunity," says Katherine Schmidt Giordano, head of Americas within the property unit of Aberdeen Asset Management Inc. in Philadelphia. Developers are still finding it difficult to raise enough cash, which has provided an opportunity for private equity. Her team is also seeing opportunities in industrial warehouse space, self-storage sites and medical buildings.

These assets remain out of reach of most retail investors, but that may be changing. Real estate fund managers are looking to diversify their sources of investing capital out of concern there will be less money from defined benefit pensions in the future. That has some firms examining ways to offer their funds to the retail market, Ms. Giordano says.