3 Ways Rising Interest Rates Are Impacting the Construction Industry

A year has passed since the Federal Reserve began hiking interest rates in an attempt to quell inflation. Last March, the Fed raised rates by 25 basis points—a move that marked its first hike since late 2018. With the dam broken, the uptrend accelerated. The Fed made four consecutive increases of 75 basis points each last year, with its final hike of 2022 bringing interest rates to a 15-year high. As things currently stand, the federal funds rate is sitting around 4.5%.

Interest rates have a tremendous impact on the economy, as evidenced most recently by the downfall of several U.S. banks. These bank failures have bred speculation that the Fed will pause further hikes. Additionally, rate hikes caused mortgage rates to fall slightly from their recent peak of 7%. Still, across the board, rates remain high and are expected to stay that way. The question, then, is what steep interest rates mean for construction. Let’s take a look at three ways rising interest rates are impacting the industry.

1. Funding challenges

Naturally, higher interest rates have the greatest impact on project funding. Construction is a cash-hungry business and, as things stand now, the cost of borrowing money is higher. This is because banks don’t like risk; their job is to mitigate it. Thus, in the wake of higher rates, banks, and other lending institutions are asking clients to come to the table with more money in hand or they’re shrinking the size of loans. Contractors who are used to borrowing money for their projects are being forced to pay more upfront—or to turn down projects altogether.

In the realm of commercial real estate especially, there has been a tremendous pullback from large money centers, with many closing the credit box—meaning they will not take new development deals at all. Loans aren’t drying up quite as quickly from small, regional lenders. But considering the recent collapse of Silicon Valley Bank and Signature Bank, regional lenders will likely face even greater scrutiny of their real estate portfolios. And once again, they may not be offering enough money to meet the needs of larger contractors. The silver lining is that alternative lending sources do exist. Expect private lenders and investors to fill the gap, as they will likely be willing to lend money a bit more freely—though still at higher-than-usual rates.

2. Reduced demand

Higher interest rates result in higher borrowing costs, which in turn leads to reduced demand. This is the case both in residential construction and in some forms of commercial real estate. The slowdown in residential construction is the result of myriad factors, including labor and materials shortages and lingering red tape from Covid-19. But also, interest rates work like gravity; as they rise, they pull asset values back down. Lower asset values translate to lower profit margins. Thus, many investors and buyers are holding onto their money as opposed to pursuing slim profit margins on a single-family build.

Demand is also drying up in some corners of commercial real estate, while projects are taking 24 to 48 months longer to complete. A higher employment rate will manifest greater demand for office space, while greater consumer spending power results in more demand for hospitality and retail. Currently, retail and hospitality are seeing reduced demand, while projects like multifamily housing complexes and infrastructure remain promising. While higher rates will still reduce profit margins on such projects, they will likely become the core focus for commercial real estate and construction companies as the government attempts to stabilize inflation.

3. Greater due diligence

The challenges and complexity of the current economic landscape change the equation for project profitability. When margins are slimmer, contractors and investors are likely to second-guess or closely scrutinize contracts. Deals are now taking shape with lower leverage, greater surveillance, and an increased focus on asset management.

For lenders, greater due diligence may include the use of professional commercial real estate inspection services, which ensure a lender knows exactly how the project is progressing before payment is drawn. But assessment should also extend to the portfolio at large. By centralizing commercial loan management, lenders have greater visibility and control over their funds.

Conclusion

The bottom line is that tremendous work and diligence are required in the current landscape. When interest rates are low and money is cheap, the possibilities for construction seem endless. But today’s climate and high rates are expected to stay that way, which means loans are more expensive, projects are less affordable, and barriers to entry are increasing. Those in the construction industry must proceed cautiously—crossing their t’s and dotting their i’s—to ensure projects are not just completed but are profitable.