BUILDING INSIGHTS: Rising interest rates and inflation impacts commercial construction

The disruptions that have occurred in commercial construction show what a difference a year makes. The Federal Reserve was holding the federal funds rate at around zero and buying billions of dollars in bonds to stimulate the economy in early 2022 and inflation was rising to near-record levels.

The Fed’s approach has changed drastically since then with The Fed raising interest rates to 5.5% and there could be more hikes in the near future. Commercial construction is being significantly negatively impacted.

The inflation rate has dropped and is less than the record setting pace, but it still is higher than the target rate of 2%. That is why the Federal Reserve has continued raising interest rates to slow down inflation even further. The higher interest rates have major effects on the commercial construction industry because loans are often needed to complete projects, since having millions of dollars in cash is not always feasible.

Interest rate increases can help with controlling inflation to some extent, but it can exacerbate supply chain issues which drive up building material costs. Higher interest rates mean that overall, construction projects will become more expensive. The Bureau of Labor Statistics indicates building material costs increased by 20% year-over-year.

The limited availability of various building products due to lack of manufacturing capacity to keep up with demand has also contributed to rising construction material costs and delayed deliveries to contractors.

Rising interest rates result in lower returns on a property as expenses for holding that property have increased. Previously, debt would often be beneficial to returns as borrowing was cheap and allowed the borrower to do more with their capital.

The cost of borrowing for commercial real estate investors will likely increase as the Fed continues to raises interest rates. Traditional commercial loans, such as those for acquiring properties or funding development projects, will become more expensive, potentially impacting the affordability of new investments.

Inflation is a major challenge for the commercial construction industry as it leads to higher building material costs, fees, and other inputs to construction projects. This may delay project completion, increase construction costs and reduce profit margins.

Commercial real estate still is widely considered to be a good long-term hedge against inflation, as owners may benefit from stable income and the ability to increase rents.

Forecasts predict spending on commercial buildings to decline by 1.4% in 2024, while industrial projects gain a modest 0.4%, with a 3.8% increase for institutional facilities.

Commercial construction firms will have to adjust their project pricing and realign their resources accordingly to combat increased costs due to higher interest rates. Firms may take on less work in order to keep costs down, which results in layoffs, either permanently or temporarily. This will further compound the challenge of an industry already facing labor shortages because layoffs are the antithesis of a solution to the labor problem.

Closing Thought

Strategic thinking will be essential to meet the challenges ahead for commercial construction. The strategy must be flexible to respond to changing circumstances and to executing the plan regardless of what happens.

Glenn Ebersole is a registered professional engineer and is the Director of Business Development at JL Architects, a West Chester-based architectural firm serving clients locally, regionally and nationally. He can be reached at gebersole@jlarchs.com or 717-575-8572.