With nearly 45 years of experience under his belt, Monte Thurmond may have seen this movie before.

The executive vice president for AECOM Hunt, an Indianapolis-based general contracting firm, understands the implications of higher interest rates on construction activity, and that strain is starting to play out now, Thurmond said.

“We’re certainly seeing a lot of pressure on almost all the commercial real estate projects because historically the majority of those types of projects are going to be taking some kind of debt instrument in order to back up any of the equity side of the equation,” said Thurmond. “[High rates] are impacting current attempts to bring projects to the market.”

For example, the city of Detroit and private developers Olympia Development of Michigan and the Related Cos. recently pushed back the construction timeline on its $1.5 billion District Detroit mixed-use project due to the current lending environment. Overall, work put on hold increased 10.1% over the past month, according to Cincinnati-based ConstructConnect’s Project Stress Index.

The Federal Reserve opted to hold interest rates steady during its latest meeting earlier this month. Officials attributed their decision to pause any rate cuts to higher-than-anticipated inflation metrics. That’s bad news for construction activity, especially on the private side.

“Interest rates rising have been a poison pill in moving construction projects forward,” said Eric Brody, founder and principal of ANAX Real Estate Partners, a New York City-based real estate capital advisory firm. “Where certain projects may have penciled out in the past no longer pencil.”

With the Fed holding steady on rates, the primary focus within the construction sector has shifted from when interest rates will decrease to how long the sector can sustain the considerable momentum it gained post-pandemic. And in a worse case scenario, the Fed could even raise again should stubborn inflation persist. 

From that perspective, even if rates stay elevated, an absence of more hikes at this point would be viewed as a positive, and could lead to a turnaround in activity by infusing it with a period of stability going forward, project watchers say.

Navigating higher interest rates

Owners and developers tend to show caution in investment during periods of higher interest rates, said Rachel Personius, associate director at Currie & Brown, a London-based project management firm with a U.S. principal office in New York.

“We’re seeing a decrease in projects without strong or clear ROIs,” said Personius. “One such example is new office build outs.”

A higher cost of debt capital tends to depress new construction, said David Bitner, executive managing director of global research at Newmark, a New York City-based commercial real estate advisory and services firm. That’s contributing to a softening in most property markets, he added.

“Interest rates are higher than they’ve been in a very long time. You’re having potential developers who are looking at projects and saying, ‘the rate of growth of NOI is going down, vacancies are rising, there’s upward pressure on cap rates, there’s less permanent financing that’s even available compared to before,’” said Bitner. “You have all the risks to their underwriting going up. That’s contributing to a slowdown in construction.”

Total construction starts ticked down 1% in March, according to Dodge Construction Network. The drop marks two months of contraction in groundbreakings, largely due to inflation and high interest rates.

However, amid uncertainty around when the Fed will ultimately slash high rates, officials have emphasized that rate hikes are also improbable. That could, ultimately, be the best news the sector is likely to get.

As the reality of a prolonged period of higher rates sinks in — no one in real estate today expects a return to the easy money of 2021 — this stability could actually signal a potential reversal in sluggish construction activity. In other words, just by leaving rates where they are, the Fed may be able to pull off the soft landing it has long sought, at least in construction, by not doing any more damage.

“The bottom line is if interest rates even stabilized, we could effectively underwrite our projects because we are aware of what the cost of capital will be,” said Brody. “So, as long as we have indicators that it’s stabilized, I think that you’d see construction begin to take off.”

Impact on projects underway

Another positive is that today’s higher rates only minimally affect projects that are already underway, an advantage for projects that have managed to put shovels to the ground, said Bitner.

“Once you already have the construction loan and you have zoning and you started the projects, there’s little advantage to putting it on pause,” said Bitner. “Once you start, you try to finish.”

Instead, the biggest impact is usually felt by projects in the early planning stages, said Personius. The latest project data confirms that view.

Apart from a slew of data center projects entering planning, most other construction categories still face slower growth in planning, said Sarah Martin, associate director of forecasting at Dodge Construction Network.

For example, traditional office and hotel projects continued to face slower momentum in April, according to Dodge. Warehouse construction planning has also remained flat.

The advantages of being public

Nevertheless, while private construction activity struggles with higher rates, public projects are faring much better, said Thurmond.

For example, in the most recent nonresidential construction spending report, the overall increase “was entirely due to increased public construction spending,” said Anirban Basu, ABC chief economist. But private projects, weighed down by higher interest rates and costs, continued to struggle.

Thurmond noted AECOM, known for its expertise in public construction such as airports, large healthcare facilities, higher education, convention centers and sports stadiums, continues to maintain a substantial volume of projects.

“We’re certainly still seeing quite a bit of activity on the public side where the public sector isn’t as impacted by the cost of interest rates because those funding sources work a little differently than they do in the private equity world,” said Thurmond. “I’m still seeing a lot of activity in the public world.”