Interest Rates and Construction: Where Are We Now?
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It’s been just over a year and a half since the Federal Reserve began increasing interest rates from recent pandemic-era lows in an attempt to help stifle inflation. Rate hikes affect credit, and the Fed's goal is to tighten lending availability in an attempt to slow demand to be more in line with a lower-supply environment, helping to abate inflationary pressures. Right now, Fed interest rates are stabilizIed around 5.5% (up from 3.25% one year ago, and 0.25% in March of 2022). This is after 11 interest rate hikes—the most aggressive rate-hiking strategy ever.
Coupled with strong job growth and consumer spending, rate hikes haven't severely hampered the economy, leading experts to agree that the tactic is working and that inflation will shrink to target rates by the end of 2024. And, recognizing that there’s a need for more data, the Fed has paused rate hikes temporarily before it makes any other moves. But globally, central banks in other countries are continuing to assess their interest rate situations, meaning the tightening effect is world-wide.
What does all of this mean for the construction industry? What is the relationship between interest rates and construction? Here’s a look at the current state of construction and rates from a financial perspective.
The Impact of Interest Rate Hikes on Construction
Few people will argue that inflation wasn’t making life difficult. However, the interest rate hikes designed to combat inflation impacted certain industries more than others. The following are some of the biggest changes the Fed’s decisions have made on the construction industry over the last year and a half.
Tighter Profit Margins
When the interest rates started to climb, so did the cost of borrowing money. Interest rates on the bank loans that so many contractors and firms were used to borrowing started swelling. Paying for these higher rates cut directly into these contractors’ profit margins.
One way to combat these tighter margins would be to charge more for the project. While some contractors did just that, this simply offloads the costs onto owners—another party feeling the squeeze of higher interest rates. When projects became unaffordable, many investors decided to freeze project spending and watch from the sidelines.
Increased Lender Scrutiny and Cash Flow
With interest rates climbing, fewer borrowers headed to banks for loans. That’s bad for the banking business, and as a result, banks had to increase their requirements and scrutiny while scaling back the amount of money they were willing to lend.
Banks started requiring contractors to come to the table with more money in hand, which meant they were willing to lend less to finance projects. Contractors with healthy cash reserves might not have had issues coming up with the funds to secure loans, but the cost of using other people’s money to fund a project climbed just the same.
Using their own cash also directly impacted these contractors’ cash flow. It prevented them from taking on as many projects as they might’ve been able to in the past and made paying suppliers, loans, and employees more difficult.
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Changes in Project Selection
When money gets expensive, every decision a contractor makes requires more in-depth analysis and care. Projects that were once profitable enough to take soon became too expensive or risky to build, and contractors had to be more selective about the contracts they took.
It’s also true that banks were more willing to lend on certain project types than others. High-demand projects like multi-family housing, distribution centers, and infrastructure were easier to secure financing for than others, and many contractors simply shifted to these project types.
Crushed Commercial Construction
One of the sectors hit hardest by the inflated rates is commercial construction. Large banks have all but shut the door on lending in industries like retail and hospitality, and investors aren’t willing to open up their checkbooks. Even though some smaller banks might have been willing to lend on these projects, many contractors found they weren’t willing to lend enough.
Contractors Sought Alternative Lending
Some contractors found a way around the combination of increased scrutiny and banking institution sheepishness. These businesses turned to private lenders and investors to help bankroll their construction projects.
But, it all comes at a cost.
Contractors seeking alternative financing methods had to pay higher-than-typical interest rates for these loans. It became less of an issue of how to get money, but more a question of whether it was worth it in the first place.
But Mortgage Rates Didn’t Drop, Either—And That Impacts a Lot
The flip side of mortgage interest rates stabilizing is that they aren’t dropping, either. And that impacts the landscape of residential construction tremendously.
Single-family housing is still in short supply. Homeowners with mortgage rates in the 3% range aren’t anxious to give these notes up for rates north of 7%. As a result, the folks in need of housing who can’t wait for inventory to become available are opting to build their homes—if they have the means.
But, since money isn’t going as far as it used to, what are the concessions? Size. The average size of a new house was about 2,350 square feet in 2021, but it’s closer to 2,200 square feet today. Higher rates are forcing homeowners to cut down the size of their new construction dream homes to make them more affordable so they can borrow less.
Builders are conceding, as well. Many are cutting the prices of the new construction homes they have on the market to increase sales and get these homes off their ledgers. Rather than continuing to hold these homes and pay excessive interest rates on loans or accounts, they’re choosing to sell the home quickly for less and simply make less profit.
It’s Only Temporary (Probably)
The rate pause is probably only temporary. The Fed has a plan to quell inflation, and many experts believe that it must stay the course a while longer to prevent reinflation from surging.
The pause is in place because the Fed wants more data before it makes any further decisions. It wants to know more about the impacts the rate hikes have had on the economy. While the plan appears to be holding the interest rates higher for a longer period, the Fed needs more data before it raises rates again and determines a reasonable timeline.
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The Interest Rate Pause Could Signal Better Days Ahead—In Theory
The rate pause could signal better days ahead for the construction industry as a whole—in theory. The Fed’s willingness to pause the hikes shows that there has been at least some improvement in the rate of inflation and the economy, and recognizing the need for more data means it’s looking to make an informed decision. And, with one more hike expected before the end of the year, this pause came at the right time.
But, this last hike could be just that: the last hike. If approved, this hike will occur before the end of the year and likely keep the rates at the prescribed “higher for longer” level. Should this approach work, the next rate adjustment might be downward, signaling a return to a new normal.
The New Normal
What does that new normal look like? If the rate of inflation slows to the Fed’s target of 2%, some experts expect mortgage rates to fall to around 5% to 6% by the end of 2024, and potentially 4.5% by the end of 2025.
Admittedly, those rates might not be the rock-bottom rates we’re used to. But it’s important to note that any relief is likely to trigger better loan opportunities, more investors, and new projects that have been on hold since the rate hikes began.
After Rate Hikes, Where Does the Construction Industry Go From Here?
It’s truly a holding pattern. There will likely be another rate hike in 2023, and that hike will increase the stress the industry is experiencing. However, if the Fed’s plan works and inflation rates slow to the target rate, construction companies will be able to secure loans, take on larger projects, and increase their profit margins over the next few years. But, unfortunately, we have to see these rate hikes through, first.
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