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What Lies Ahead for Housing ETFs?

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There’s no denying that U.S. housing data has been weak in recent months, as inventory shortage has started taking toll on sales’ pace and pushed average home prices higher nationwide. Additionally, the U.S. Government’s latest move of imposing tariff on imported steel and aluminum is also niggling investors.

Nonetheless, overlooking the sector will not be advisable, as the industry looks equally good for the balance of 2018 banking on strong fundamentals, signaling a profitable investment opportunity.Consistent job growth along with seemingly high homebuilders’ confidence is expected to show strong footing.

What Numbers Have to Say

After performing remarkably well in 2017, housing sales are trending down for both existing and new homes. Sales of new homes in the United States dropped 1.5% in April after gaining in March, per the latest report of the Commerce Department. In fact, new home sales faltered in three of the last four months this year. Housing starts and building permits also fell 3.7% and 1.8%, respectively, in the month.

Moreover, existing-home sales faltered in April on both a monthly and annualized basis, according to the National Association of Realtors, after moving upward for two straight months. Total existing-home sales decreased 2.5% in April from March. With this decline, sales are now 1.4% below a year ago and have fallen year-over-year for two straight months. (Read: Best Leveraged ETFs to Start June)

Hang-Ups

A tight labor market, limited land availability and a constrained mortgage environment are restricting homebuilders to respond to growing demand. Meanwhile, there are other factors that can deal a fresh blow to the housing industry. The U.S. Government’s recent move of imposing tariff on imported steel and aluminum has spurred concerns among investors about certain U.S. sectors, particularly construction.

The cost of goods used in construction increased 6.4% in April at the fastest year-over-year rate since 2011. Prices surged for a wide range of building materials, including many that are subject to proposed tariffs, which is expected to further push prices higher and cause scarcities, per the latest report by the Associated General Contractors of America of Labor Department. The report further revealed that the new data indicates many firms are already being squeezed by higher materials prices that they are unable to pass along to their customers.

This apart, there are concerns over chances of a series of interest rate hikes by the Federal Reserve or Fed. The Fed last raised interest rates in March, by a quarter of a percentage point. The target range for benchmark short-term interest rate stands between 1.5% and 1.75%. This was the sixth-rate hike undertaken by the Fed since 2015. The Fed expects to increase interest rates two more times in 2018. Fed officials now project a median federal funds rate of 2.9% by the end of 2019, which indicates three rate hikes in 2019 against two predicted in the last Fed meeting in December 2017. They expect the rate to move up to 3.4% in 2020 from the previous expectation of 3.1%.

Mortgage rates, which loosely follow the yield on the 10-year Treasury, started the year at around 4% but began rising thereafter. Mortgage rates are surging in proportion to U.S. government bond yields in anticipation of higher rates of inflation and further monetary tightening by the Fed.

Additionally, to make up for rising labor costs, homebuilders are being compelled to raise home prices to maintain margins that is expected to deter entry-level homebuyers. April’s median sales price of existing homes grew 5.3% from the comparable period a year ago, marking the 74th straight month of year-over-year gains. In 2017, prices increased 5.8%, rising for the sixth straight year. Additionally, the median sales price of new homes sold in April was 0.4% higher than a year ago. Overall, rising prices may keep home buyers at bay with many postponing their search for the time being.

All is Not Lost

Although homebuilders acknowledge the rise in labor shortage and land/labor cost, they in general expect the housing market to continue to recover this year in tandem with steady economic growth. (Read: Mid-Cap ETFs to Shrug Off Trade, Fed & Overvaluation Woes)

Consistent job growth, growing interest from first-time homebuyers as well as seemingly high homebuilder confidence are adding to the momentum. Although Fed policymakers are looking at three rate hikes this year, setting the stage for an increase in mortgage rates, Americans are seeing wages growing at the quickest pace since the end of the last decade.

Despite the month-over-month hiccups, new home sales were up 11.6% year over year in April. Additionally, April housing starts were up 10.5% year over year on a 7.2% increase in single-family homes, and a 19.1% surge in apartments. Permits were 7.7% above the April 2017 rate of 1.26 million units prompted by a 7.9% surge in single-family homes and 6.4% growth in buildings with five units or more. (Read: Regional Bank ETFs—What Investors Need to Know)

Overall, solid builders’ confidence in the market along with robust economic growth and a consistent job market raise hopes for the U.S. housing market. Builders’ confidence increased two points to 70 in May from April. Importantly, the reading was above the 50 mark in the first five months of 2018, indicating a favorable outlook. Moreover, this is the fourth time in 2018 that the index has reached 70.

ETFs to Tap the Sector

We take a look at three construction ETFs that are poised to gain from the upswing in the housing market. (See all industrials ETFs here)

SPDR S&P Homebuilders ETF (XHB)

The fund employs a replication strategy in seeking to track the performance of the S&P Homebuilders Select Industry Index, which is an equal-weighted index of the homebuilding segment of a U.S. total market composite index. The fund has an expense ratio – an annual fee – of 0.35%.

The top three industries are Homebuilding (32.7%), Building Products (31.7%) and Home-furnishing (10.7%). The top three holdings are Lowe's Companies Inc. (5.3%), Williams-Sonoma Inc. (5.2%) and Home Depot Inc. (5%). This fund holds 35 stocks with about 46.5% invested in the top 10 holdings.

iShares U.S. Home Construction ETF (ITB)

ITB tracks the Dow Jones U.S. Select Home Construction Index, which measures the performance of the U.S. home construction sector.

The top three holdings are D.R. Horton Inc. (11.5%), Lennar Corp. (11.3%) and NVR Inc. (8.8%) with about 59.3% invested in the top 10 holdings. The fund is heavily exposed to the Homebuilding sector (64%), followed by Building Products (14.9%) and Home Improvement Retail (10.5%).

This fund holds 47 securities in its basket and has an expense ratio of 0.44%.

PowerShares Dynamic Building & Construction Fund (PKB)

PKB seeks to match the performance of Dynamic Building & Construction IntellidexSM Index, which is composed of U.S. building and construction companies. The top three sector allocations are Industrials (42.8%), Consumer Discretionary (36.4%), and Materials (20.8%). Yet, the fund is more expensive than many other options in the space, charging 63 basis points in annual fees.

Among the 30 stocks in the basket, NVR, Martin Marietta Materials Inc. and Tractor Supply Co hold the top spots with 5.1%, 5.1% and 5%, respectively, of total net assets. 

To Sum Up

Investors’ sentiments could be dampened by the possibility of an interest rate hike. Also, skilled labor shortage is a cause for concern as demand continues to rise. Rising materials, land and labor costs too are restricting margins as these limit homebuilders’ pricing power.

However, there are plenty of reasons to be optimistic about the broader housing sector over both the short and the long terms. In this context, the above-mentioned ETFs might be sound bets to play the sector.

 

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SPDR-SP HOMEBLD (XHB): ETF Research Reports
 
ISHARS-US HO CO (ITB): ETF Research Reports
 
PWRSH-DYN BLDG (PKB): ETF Research Reports
 
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