Elevated Interest Rates are Expected to Curb CRE Development in 2024
Construction starts hindered. A tight labor market, strong wage growth, and elevated costs for food, services and housing have all contributed to keeping overall inflation elevated. The Fed has responded to this by hiking interest rates. As of late March, the overnight lending rate was at 4.75 percent, the highest level since December 2007. Also, despite a retreat in shipping costs and the average prices of steel and gasoline in recent quarters, construction materials costs remain elevated on a historical basis. Both higher interest rates and steeper building costs are having an impact on the commercial real estate construction sector.
Costs for construction remain elevated. While projects that have already broken ground or secured financing are still progressing, several external factors are limiting the start of new developments. Banks are approving fewer construction loans compared to previous years as lenders tighten underwriting due to increased risk exposure. If developers manage to secure loans, they come with rates well above pre-pandemic levels. Additionally, material costs for developers are still 33.5 percent higher than pre-pandemic levels, and wage growth in the construction sector registered 5.8 percent in 2022, outpacing the private sector average. Although the impact on new supply will be minimal in the near term, higher costs for financing, building materials, and labor are expected to slow down future development.
The industrial sector is affected. Supply chain disruptions and changes in consumer spending habits have increased the demand for industrial space, leading to a significant rise in new projects. Supply additions are expected to reach a two-decade high in 2023. However, a slowdown in development is anticipated as construction starts already declined by approximately 40 percent in the fourth quarter of 2022 compared to the previous three-month period. Additionally, Amazon, which accounted for around 16 percent of all warehouse starts in the past three years, recently announced plans to halt new construction. Fewer groundbreaking activities this year will result in fewer property deliveries in the future.
Retail and office construction will slow down. While the total square footage set to be delivered for both office and retail properties is projected to increase year-over-year in 2023, new proposals in these sectors indicate signs of deceleration, and construction starts for both property types are expected to decline this year. The demand for brick-and-mortar retail has changed due to the growing prevalence of online and omnichannel shopping, while work-from-home trends have led to a decline in office usage rates. The limited competition from new supply should support performance metrics at existing retail and office properties.
Developers are optimistic about multifamily properties. Despite elevated interest rates, recent bank failures, and increased material and labor costs, new development starts for many property types are being curbed. However, the apartment sector continues to experience record inventory growth. Completions in 2023 are expected to surpass 400,000 units for the first time in over 30 years. Moreover, multifamily project starts in February of this year reached the second-highest monthly figure in three decades, indicating that momentum is not slowing down for new construction in this sector. The ongoing national housing shortage and significant barriers to homeownership are boosting developers' confidence and are likely to drive the development of new communities in the near to mid-term.