Housing trends favor builders focused on entry-level buyers

It's lining up to be another strong year for investors who own homebuilding stocks.

Shares of the 10 builders with the most completed sales in 2016 are up an average of 60.8 percent. And exchange-traded funds, or ETFs, that invest in homebuilders have also notched gains that beat the broader U.S. stock market.

While many economists expect U.S. housing market growth trends to continue next year, homebuilders that focus on entry-level buyers could be the safest bet for further gains.

"The demand, as we see it, is likely to continue to be pretty good, but the builders that will most benefit will be those who have a focus on the low-end home buyer," said BTIG analyst Carl Reichardt.

A growing economy, solid job market, low unemployment rate and low mortgage interest rates have helped drive demand for homeownership this year. The trends have also driven gains for some ETFs with exposure to homebuilders. The SPDR S&P Homebuilders ETF is up 27 percent this year, while the iShares U.S. Home Construction ETF is up 54.9 percent.

Many economists said they expect the economic and housing market trends to continue next year, including further increases in sales of new homes and prices.

Still, favorable market trends may not be enough to translate into more big gains for builders. Valuations are close to where they have traditionally peaked, Reichardt pointed out.

Earlier this year, D.R. Horton acquired land developer Forestar Group in a deal that helps beef up the builder's access to land that's been cleared for new construction. Last month, Lennar bought rival CalAtlantic Group in a $5.7 billion deal, not including $3.6 billion in debt, that will create the nation's largest homebuilder.

The tax overhaul making its way through Congress is likely to have an impact on the housing market, which could affect builder stocks.

The projected corporate tax cut would benefit homebuilders, given that they tend to have high tax rates. The group of builders that BTIG tracks has an average tax rate of 34 percent. The proposed tax overhaul bills would reduce corporate taxes to 20 percent.

A proposal to limit the mortgage interest deduction on newly purchased homes to the first $500,000 of the loan, instead of the current $1 million limit, would particularly affect companies building pricier homes on the U.S. coastal metro areas, such as Toll Brothers.