Rising interest rates, the ongoing energy crisis, and lingering high construction costs are prompting property investors to rethink whether they back new developments. These three factors, especially, have exacerbated the cost to develop real estate assets. In the short term, at least, it’s likely the challenges will remain.
Let’s see how these issues are currently affecting commercial real estate investment.
Rising Construction Costs
In 2021, construction costs increased 11.5% — much higher than the average 2-4% historical trend. By the end of 2022, costs may rise by just over 14%. Construction material prices increased 25% last year, according to the Bureau of labor Statistics. CoreLogic’s Quarterly Construction Insights Q3 2022 report found that:
- Lumber (+27%) and plywood (+18%) prices spiked in April this year and while prices have begun to come down, the costs remain high.
- Asphalt shingles (+21%), fire sprinkler pipe (+15%), PVC pipe (+47%), slab doors (+21%), remain high, with prices continuing to rise.
- The most significant cost increases for residential property construction have occurred in Utah (+5.6%), Vermont (+5.3%) and Wyoming (+5.2%), with the average increase growing 4.1% between Q2 2022 and Q3 2022.
- The number of building permit authorizations from January – August 2022 were highest in the southern region (about 450K) and lowest in the northeast region (less than 200K).
- Single units led with the greatest number of permits, followed by 5 units or more and 2 units — 3 and 4 units had the lowest number of permits.
Labor shortages and ongoing supply-chain issues have influenced construction costs as have the ongoing conflict in Ukraine and lockdowns in China. Also keeping prices from falling? Soaring energy costs — both natural gas and unprocessed energy materials have seen an incredible 126% price increase. With higher energy costs comes higher transportation costs that — according to Oxford Economics — have a low value-to-weight ratio.
Rising Energy Costs
Although gas prices have fallen in recent weeks from a nationwide high of more than $5 per gallon — the highest price in history — in June 2022, other energy costs continue to spike. And those fuel prices didn’t just impact those with cars and trucks. Companies added surcharges to cover their increased shipping costs, for example. Airline tickets became more expensive as did cab and Uber fares.
Unfortunately, electric bills are straining residential and commercial budgets alike. While the U.S.’s annual inflation rate fell to 8.3% in August — and core inflation sat at 6.3% — electricity prices have jumped over 15% since January. Why? Because the cost of natural gas used to generate almost 40% of the country’s power has also increased. Extreme temperatures and longer-than-normal heat waves plaguing much of the country haven’t helped either. The National Energy Assistance Directors Association (NEADA) estimates that cooling costs for the average family increased nearly $150 to nearly $600 this summer. NEADA estimates people will spend 17% more — just over $1,200 — to heat their homes this winter, and families relying on natural gas will spend up to 34% more.
Companies and other commercial entities will also see much higher energy bills as we move into the fall and winter. The Consumer Energy Alliance (CEA) estimated businesses and manufactures will spend at least $41 billion more this year for energy.
Rising Interest Rates
Also influencing construction costs? More expensive debt. In June and July, the US Federal Reserve instituted a 75 basis-point increase to its federal funds rate. We haven’t seen single increases this high in almost 30 years. Currently, the federal funds rate sits between 2.25% and 2.50%, and many economists anticipate another rate hike of 0.75% at the Fed’s September meeting. Should inflation not slow further, the Fed may implement additional rate hikes later this year and into 2023.
Pivoting to New Strategies
What now? Do investors continue seeking out development-related investments? It appears that investors have been pivoting to acquisitions rather than new development. Acquisitions carry lower risks and require less project management or deep experience.
Additional rate hikes that appear likely also dampen enthusiasm for — and ability to execute — development deals, at least in the short term. Consider this reality: currently trading construction loans have an average 10% less loan-to-value than loans originating in January. Q1 loans traded between 100 and 300 basis points lower relative to the Secured Overnight Financing Rate than a loan in Q3.
It doesn’t make good financial sense to sign a deal at 50% of cost in borrowing terms — development deals don’t work that way. Institutions remain leery of these loans, since higher costs pose much greater risk for lenders and other capital providers, according to one manager who provides equity and debt to development projects.
Outlook for 2023
So should investors wait out the market or try to find a “good deal” somewhere? Cautious investors may deem waiting to invest in private real estate a safe bet.
Many industry experts believe suggests construction costs will stay high through the beginning of 2023 and supply side disruptions will linger as well. Continued inflation will drive construction project cancellations, cost overruns, and project delays, and create other headaches.
Perhaps it’s best to play the waiting game or look for investments in already established construction, at least for now.
Are you a commercial real estate investor or looking for a specific property to meet your company’s needs? We invite you to talk to the professionals at CREA United: an organization of CRE professionals from 92 firms representing all disciplines within the CRE industry, from brokers to subcontractors, financial services to security systems, interior designers to architects, movers to IT, and more.
