Homebuilder ETFs have outperformed this year thanks to demand for newly-built homes, but they may have reached an inflection point amid rising mortgage rates and a pullback in construction.

Banner Year For Homebuilder ETFs May Be Turning

In the past month, exchange-traded funds (ETFs) that track homebuilders' performance—such as the SPDR S&P Homebuilders ETF (XHB), Invesco Building and Construction ETF (PKB), and iShares U.S. Home Construction ETF ()—have all fallen roughly 5%.

This is a departure from the rest of the year up to that point. ITB is up almost 28% so far this year, with XHB and PKB trading 26% and 22% higher, respectively. At its peak in July, ITB was up more than 47% year-to-date, while XHB and PKB were each up roughly 40% at the time.

Shares of homebuilders like D.R. Horton (DHI), KB Home (KBH), and Lennar (LEN), which feature prominently in the portfolios of some homebuilder ETFs, were boosted by the resilience of the U.S. housing market.

Sales of newly built homes have boomed this year amid a limited inventory of existing homes for sale, as homeowners who locked in record-low mortgage rates early in the pandemic have been reluctant to sell.

Newly built homes accounted for almost a third of all home sales for the quarter ending in June, marking a second-quarter record and just below the all-time high of 34.5% set in the first quarter last year, according to Redfin.

So, What's Changed?

A confluence of factors may have brought the housing market to an inflection point, as evidenced in recent economic data.

Construction has slowed: U.S. housing starts tumbled last month to their lowest since June 2020. Meanwhile, sales of newly built homes also fell unexpectedly, to 675,000 from 739,000 in July, coming in well short of expectations of 700,000.

In theory, the lack of housing supply drove up prices, which provided a great opportunity for homebuilders to bridge that gap with newly constructed homes. However, the Federal Reserve's campaign against inflation has driven up interest rates, making mortgages unaffordable and hurting construction companies as well.

The average rate on a 30-year mortgage guaranteed by Freddie Mac rose to 7.19% last week, up from less than 6.1% in February. Rates have more than doubled since early 2022 before the Fed's rate hikes led to a surge in borrowing costs for consumer loans.

For example, KB Home's gross profit margin for the latest quarter was down 5.2 percentage points from the year-ago quarter, partly reflecting higher mortgage rates and construction costs.

"The margin result relative to the prior year was primarily due to price decreases and other concessions aligned to housing market conditions, particularly the higher mortgage rate environment as well as higher construction costs and a shift in the mix of homes delivered," Chief Financial Officer (CFO) Jeff Kaminski said on the company's latest earnings call.