High interest rates persist, contractors and owners adopt a wait-and-see approach

With nearly 45 years of industry experience, Monte Thurmond may have seen similar market cycles before. As executive vice president of AECOM Hunt, an Indianapolis-based general contractor, Thurmond knows the impact high interest rates have on construction activity, and that pressure is now beginning to show.

"We definitely see significant pressure on nearly all commercial real estate projects because historically, most of these projects have relied on some form of debt instrument to support the equity portion," 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, the number of paused projects increased by 10.1% over the past month, according to the Project Stress Index from Cincinnati-based ConstructConnect.

The Federal Reserve decided to hold interest rates steady at its latest 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 in the private project sector.

"Rising interest rates have become poison for advancing construction projects," said Eric Brody, founder and principal of ANAX Real Estate Partners, a New York-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 focus has shifted from when rates will be cut to how long the industry can sustain its post-pandemic momentum. And in the worst-case scenario, if inflation remains stubborn, the Fed could even raise rates again.

Project observers note that from this perspective, even if rates remain high, as long as they don't rise further, it can be seen as a positive signal that could inject a period of stability to drive activity back up.

Strategies for coping with high interest rates

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

"We are seeing a reduction in projects that lack strong or clear returns on investment," Personius said. "New office fit-out projects, for example."

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

"Interest rates have been at elevated levels for a long time. When prospective developers look at projects, they see declining net operating income growth, rising vacancy rates, upward pressure on cap rates, and less available long-term financing," Bitner said. "All underwriting risks are rising, which is causing construction activity to slow."

According to Dodge Construction Network, total construction starts fell 1% month-over-month in March. This decline 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 Federal Reserve will ultimately cut rates, officials have emphasized that rate hikes are also unlikely. That may ultimately be the best news the industry could get.

As the reality of a potentially prolonged period of high interest rates sets in—no one in the real estate world now expects a return to the easy-money environment of 2021—this stability could actually signal a reversal in sluggish construction activity. In other words, by simply holding rates steady, the Fed could achieve the soft landing it has long sought in the construction sector without causing further damage.

"At the end of the day, if rates stabilize, we can underwrite projects effectively because we know the cost of capital," Brody said. "So as soon as we see signs of stabilization, I think construction activity will start to pick up."

Impact on projects under construction

Bitner said another positive factor is that current high interest rates have had minimal impact on projects already under construction, which is an advantage for those that have already broken ground.

"Once you've secured a construction loan, completed zoning, and started the project, there's little benefit to pausing," Bitner said. "Once you start, you try to finish."

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

Sarah Martin, associate director of forecasting at Dodge Construction Network, said that aside from a batch of data center projects entering the planning stage, most other construction categories continue to face slowing growth in planning. For example, according to Dodge, traditional office and hotel projects continued to lose momentum in April, while warehouse construction planning remained flat.

Advantages of public projects

However, while private construction activity is dragged down by high interest rates, public projects are faring much 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, hampered by high interest rates and costs, continue to struggle.

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

"We do 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 is different from the private equity space," Thurmond said. "I still see a lot of activity in the public sector."