High Interest Rates Continue to Pressure: Contractors and Owners Adopt a Wait-and-See Approach

With nearly 45 years of industry experience, Monte Thurmond is likely no stranger to the current situation. As executive vice president of AECOM Hunt, an Indianapolis-based general contracting company, Thurmond knows well the profound impact high interest rates have on construction activity, and that pressure is now gradually becoming apparent.

"We do see significant pressure on almost all commercial real estate projects because historically most of these projects have relied on some form of debt instrument to support the equity gap," Thurmond said. "High interest rates are affecting current attempts to bring projects to market."

For example, the city of Detroit and private developers Olympia Development of Michigan and Related Cos. recently delayed the construction timeline for their $1.5 billion District Detroit mixed-use project due to the current lending environment. Overall, according to the Project Stress Index from Cincinnati-based ConstructConnect, the number of stalled projects increased by 10.1% over the past month.

The Federal Reserve chose to hold interest rates steady at its most recent meeting earlier this month. Officials attributed the decision to pause rate cuts to higher-than-expected inflation readings. This is not good news for construction activity, especially for private-sector projects.

"Rising interest rates have become a poison hindering the advancement of construction projects," said Eric Brody, founder and principal of ANAX Real Estate Partners, a New York City-based real estate capital advisory firm. "Projects that may have penciled out in the past are no longer viable."

With the Federal Reserve holding rates steady, the construction industry's core focus has shifted from "when will rates be cut" to "how long can the industry withstand the enormous momentum accumulated after the pandemic." And in the worst-case scenario, if inflation remains stubborn, the Fed could even raise rates again.

From this perspective, even if rates remain elevated, as long as they don't rise further, it could be seen as a positive signal and help revive activity by injecting a period of stability, project observers said.

Strategies for coping with high interest rates

Rachel Personius, associate director at Currie & Brown, a project management firm headquartered in London with its main U.S. office in New York, noted that owners and developers tend to be cautious about investment during periods of high interest rates.

"We are seeing a reduction in the number of projects lacking strong or clear returns on investment," Personius said. "One example is new office fit-out projects."

David Bitner, executive director of global research at Newmark, a New York City-based commercial real estate consulting and services firm, said that higher costs of debt capital tend to dampen new construction activity. He added that this is leading to weakness across most property markets.

"Interest rates have been at elevated levels for a long time. When potential developers look at projects, they see that 'net operating income growth is declining, vacancy rates are rising, cap rates are under upward pressure, and long-term financing available is scarcer than before,'" Bitner said. "All the risks they underwrite are increasing, and that is causing construction activity to slow."

According to Dodge Construction Network data, total construction starts fell 1% month-over-month in March. This marked the second consecutive month of contraction in new project starts, primarily attributed to inflation and high interest rates.

However, amid uncertainty over when the Fed will ultimately cut rates significantly, officials have emphasized that rate hikes are also unlikely. That may ultimately be the best news the industry can get.

As expectations of prolonged high interest rates gradually take hold—no one in the real estate world now expects a return to the loose money era of 2021—this stability could actually signal a potential reversal in sluggish construction activity. In other words, by simply holding rates steady, the Fed might achieve its long-sought soft landing without causing further damage, at least in the construction sector.

"The key is that if rates merely stabilize, we can effectively underwrite projects because we know what the cost of capital will be," Brody said. "So, as soon as we see signs of stabilization, I think construction activity will start to take off."

Impact on projects under construction

Another positive factor is that current high interest rates have minimal impact on projects already underway, which is a major advantage for those that have already broken ground, Bitner said.

"Once you've secured a construction loan, obtained planning approvals, and started the project, there is little benefit to pausing," Bitner said. "Once you start, you work to complete it."

Instead, the biggest impact typically falls on projects in the early planning stages, Personius said. The latest project data confirms this view.

Aside from a batch of data center projects entering the planning pipeline, most other construction categories continue to face slower growth in planning, said Sarah Martin, associate director of forecasting at Dodge Construction Network.

For example, according to Dodge data, traditional office and hotel projects continued to face slower momentum in April. Warehouse building planning also remained flat.

Advantages of public projects

That said, while private construction activity struggles under high interest rates, public projects are performing better, Thurmond said.

For example, in the latest nonresidential construction spending report, overall growth was "entirely attributable to increased public construction spending," said Anirban Basu, chief economist at ABC. But private projects, weighed down by high interest rates and costs, continue to struggle.

Thurmond noted that AECOM, known for its expertise in public buildings such as airports, large healthcare facilities, higher education, convention centers, and sports venues, still maintains a substantial project pipeline.

"We do still see quite a bit of activity in the public sector because the public sector is less affected by interest rate costs, and the way its funding sources operate differs from the private equity world," Thurmond said. "I still see a lot of activity in the public sector."