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How To Profit From The Real Estate 'disaster'

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ETFs That Win Big With a Housing Bust

By Brett Arends

Mutual Funds Columnist

7/2/2007 10:53 AM EDT

They say fortune favors the brave.

But only time will tell whether it's brave or foolish to run into this falling house. The situation right now: The housing market is in collapse. The question: Is this the right time to buy?

If not to buy a new house, then how about an exchange-traded fund that invests in housing stocks? And if not that ETF, then how about call options on the fund? You could get all of the upside in any kind of rally ... and you'll only risk a small stake.

It's not for everyone.

But then there are millions of Americans waiting for house prices to come down so they can buy a new home. They might want to look at this nifty little Wall Street trade, which they can make through any broker as insurance against the market recovering while they wait.

Let's start by taking a step back.

If you think real estate agents are miserable about the housing market, you should talk to Wall Street. Bulls have been slaughtered over the past year after prematurely claiming to spot the bottom in collapsing housing prices.

This past week, homebuilder Lennar (LEN - Cramer's Take - Stockpickr - Rating) was the latest to warn that things are even worse than expected. Prices are evaporating and they see no bottom.

Ouch.

No wonder the homebuilding stocks, from upmarket Toll Brothers (TOL - Cramer's Take - Stockpickr - Rating) to Pulte Homes (PHM - Cramer's Take - Stockpickr - Rating), are plunging to multiyear lows.

There is plenty of reason to think things will get worse before they better. The National Association of Realtors reports inventories have now skyrocketed to their highest levels since the crash of the early 1990s. The backlog of unsold homes sitting on the market has now hit the equivalent of nine months' supply.

Professor Bill Wheaton, a housing expert at the Massachusetts Institute of Technology, expects prices to keep falling for another 18 months before hitting rock bottom at the end of 2008. He says the meltdown of subprime mortgages is likely to get worse over the next year as rates reset. He predicts waves of foreclosures and auctions, and bankruptcies in bubble hot spots such as Las Vegas, Miami and Phoenix. Overall, he thinks average prices nationwide are likely to fall another 20%.

One of the few regions where the market is still looking OK is the Pacific Northwest, he adds.

But when it comes to Wall Street, what matters isn't what's going to happen next.

It's what odds they're offering.

And right now, the homebuilding sector is pretty much priced for disaster. So there's a pretty good chance that anything better than that would produce a rally.

When it comes to homebuilding stocks, one of the best ways to measure the valuation is to compare the share price to the value of their land, unfinished homes and other assets.

Most of the time, homebuilders trade at a big premium to the value of their assets. Over the last 17 years, they've usually traded between 1.5 and 3 times this so-called "book" or net asset value.

Right now? This week's selloff has left shares in Toll Brothers and KB Homes (KBH - Cramer's Take - Stockpickr - Rating) each trading at just 10% over book value. DR Horton (DHI - Cramer's Take - Stockpickr - Rating) shares have fallen to 4% below book value, while Pulte Homes has actually fallen 11% below book value.

In each case this is a fraction of where the stocks usually trade. The last time we saw valuations this low was in late 1990, and that was in the depth of the last real-estate crash. And that time around, the shares quickly rallied -- even though the housing market itself took years to get back in the swing.

This certainly doesn't mean the shares can't fall further. (For Nicholas Yulico's take on why builder stocks could see more trouble, click here.) But it does mean Wall Street has already pretty much assumed disaster will happen.

But if you want to bet the other way, two ETFs will spread your bets across the entire homebuilding sector. ETFs are like mutual funds, except they trade throughout the day on the stock market and you buy and sell them like ordinary shares.

The first is iShares' Dow Jones U.S. Home Construction Index fund (ITB - Cramer's Take - Stockpickr - Rating), which was launched just over a year ago at $49.50. It plunged this week to a fresh low of $31.31. The second ETF is State Street's S&P Homebuilders ETF ( XHB - Cramer's Take - Stockpickr - Rating). Both funds invest in all the top homebuilders and in related construction stocks.

If you are thinking about buying a home right now, but are waiting in the hope prices fall further, there is a special feature of the Homebuilders ETF you should know about. Instead of buying the fund, you could buy call options.

That's like a wager on the shares rising.

If the sector rallies, you'd get huge upside. But if the fund's shares stay where they are, or if they fall, all you lose is your small stake. See it as insurance against the real estate market rallying while you look for a new home.

The Homebuilders ETF shares ended last week at just $30.23. Call options that give you the right to buy those shares at $35, at any time between now and December, cost just 95 cents.

These are high-risk plays. The best way to view call options is as a wager, not an investment. If you spend $1,000 on options you have a very real chance of losing that $1,000. In fact, if the shares stay below $35 it's guaranteed.

But at least your downside is limited to that $1,000. And if the housing market recovered, you'd make a big profit. If the ETF rallied just to the $40 price it saw in January, you'd get back $5,000, including your initial $1,000 stake. That's because you could still buy the shares for $35, and then sell them for $40.

A 4-to-1 payoff. You pay your money and you take your chances.

Source: http://www.thestreet.com/s/how-to-profit-f...ml?puc=googlefi

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