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The rally in the U.S. housing market has fizzled due to higher mortgage rates, which are taking a toll on builder confidence and consumer demand. This is especially true as mortgage rates topped the highest level since 2000 last week, dampening housing market activity.

According to Freddie Mac data, the average rate for the 30-year fixed mortgage climbed to 7.57% in the week ending Oct. 13, up from 7.49% in the previous week and 6.92% in the year-ago week. This squeezed affordability, hitting both new and existing home sales markets, and sparked a slowdown in home sales, posing a challenge particularly for first-time buyers.

This pushed the homebuilder ETFs space down into the red during the trading week. In particular, iShares U.S. Home Construction ETF (ITB - Free Report) stole the show, tumbling 4.6% on Oct. 12. Invesco Dynamic Building & Construction ETF (PKB - Free Report) and SPDR S&P Homebuilders ETF (XHB - Free Report) declined 3.8% each on the same day.

Higher mortgage rates have a dual impact on the housing market, reducing affordability for buyers and strengthening the rate lock-in effect for sellers. Additionally, homebuying demand remains at a three-decade low.

Sam Khater, Freddie Mac’s chief economist, said that several factors, including shifts in inflation, the job market, and uncertainty around the Federal Reserve’s next move, are contributing to the highest mortgage rates and pulling back homebuyer demand.

Home loan purchase applications have also fallen to multi-decade lows and are now nearly 20% below last year’s pace, according to the Mortgage Bankers Association. However, there’s been a pickup in applications for adjustable-rate mortgages. Meanwhile, builder sentiment slipped into negative territory in September for the first time in five months.

Below, we profile the ETFs mentioned above in detail and discuss some of the specifics behind their recent slump:

iShares U.S. Home Construction ETF (ITB)

This ETF provides exposure to U.S. companies that manufacture residential homes by tracking the Dow Jones U.S. Select Home Construction Index. With AUM of $1.9 billion, the ETF holds a basket of 46 stocks with a heavy concentration on the top two firms. The fund charges 40 bps in annual fees, and it trades in a heavy volume of around 3.7 million shares a day on average.

SPDR S&P Homebuilders ETF (XHB)

This ETF provides exposure to homebuilders with a well-diversified exposure across building products, home furnishing, home improvement retail, home furnishing retail, and household appliances. It tracks the S&P Homebuilders Select Industry Index, holding 35 stocks in its basket.

The ETF is the most popular option in the homebuilding space, with AUM of $1 billion and an average daily volume of 1.2 million shares. The fund charges 35 bps in annual fees.

Invesco Dynamic Building & Construction ETF (PKB)

This ETF follows the Dynamic Building & Construction Intellidex Index, holding 31 well-diversified stocks in its basket, with none accounting for more than 5.8% of the assets. The ETF has amassed assets worth $205.9 million, and it sees a lower volume of roughly 49,000 shares per day on average. Its expense ratio comes in at 0.62%.

What Lies Ahead?

With the latest decline, the homebuilder index has fallen 7.3% over the past month. However, it is still one of the best-performing sectors of 2023, gaining 23.7% compared with 13.3% rise for the S&P 500 Index. The outperformance came despite the fact that homebuilding is one of the most sensitive sectors to changes in interest rates.

The solid gains will likely remain for the rest of the year, as the Fed hinted that rates have peaked and we might see a slump in rates in 2024. Per the latest minutes, the central bank agreed that policy should remain restrictive for some time until the committee is confident that inflation is moving down sustainably toward its objective.

Further, the homebuilder has a solid Zacks Sector Rank (in the top 22%), suggesting continued outperformance in the coming months. The three funds detailed above also all have a Zacks ETF Rank #2 (Buy), suggesting that they have the potential to outperform in the coming months.

Given the strong outlook but somewhat bearish near-term sentiments, investors may want to consider staying on the sidelines for the time being. However, risk-tolerant, long-term investors may want to consider this recent slump a buying opportunity, should they have the patience for extreme volatility.

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