The story isn’t shocking to anyone who’s followed commercial construction: High interest rates and the rising costs of materials and labor are making it more expensive to build commercial real estate developments.
And the stark reality? These challenges aren’t going away. Even if the Federal Reserve Board no longer raises its benchmark interest rate, rates aren’t going back to the 3% range anytime soon. And even though the escalation of material cost increases has slowed, the price of switchgear, roofing components and steel aren’t dropping anytime soon.
On the positive side? The commercial construction companies navigating the Midwest are picking up plenty of public work to help offset the slowdown in private-sector construction. And they have gotten awfully good at mastering the art of scheduling so that projects aren’t delayed by long lead times for switchgears and other electrical components.
In fact, the commercial construction industry has shown plenty of resilience in overcoming the challenges of today’s economic climate. And the professionals working the Twin Cities market say that this resilience will help commercial construction companies weather this storm.
A new-construction slowdown fueled by higher interest rates
Tom Schmall, vice president of project development for Minneapolis-based Mortenson, said that those commercial construction projects that are moving forward are those designed for very specific users.
Spec construction, though, has come to a standstill, Schmall said, even in sectors such as multifamily were demand for space remains high.
“Some of it is a conundrum,” Schmall said. “You talk about housing. Apartment deals are happening, but not at the pace they once were. Still, there’s a huge demand for housing. With such a strong need, you’d think that at some point the fever has to break. We need more housing. But the higher rates are keeping projects on the backburner.”
Troy Blizzard, vice president and general manager with Mortenson, said that everyone in the commercial real estate business is talking about interest rates today. He said that he himself has never talked about the Federal Reserve Board so much in his life.
Blizzard compared it to the supply chain issues that commercial construction companies faced during the height of COVID: Everyone knew about those issues, too, and everyone was hyper-focused on them. The same is happening today with interest rates, with everyone in the real estate industry waiting to see when sales and development activity will rebound.
Blizzard, though, said that not all sectors have been equally hit by the higher rates. He pointed to high-tech or industrial manufacturing. Activity remains strong in this area, even when it comes to sales and new construction, he said.
“The high-tech businesses are still humming. That business can overcome the interest-rate discussions,” Blizzard said. “There is no slowdown in people wanting data centers even with the higher rates. But other markets like hospitality and residential are seeing a slowdown because of higher rates. The impact of interest rates is broad, and everyone knows it.”
Cathy Schmidt, president and chief executive officer of Minneapolis-based Stahl Construction, said that higher interest rates have had a significant impact on the multifamily sector, with the higher rates slowing the development of much-needed new apartment units.
“There appears to be some level of stoppage in terms of new development or projects that were in the process,” Schmidt said. “Today, developers are waiting to see when interest rates will stabilize or go down. The higher rates are making the numbers harder to pull together to make a deal work.”
Schmidt said that she has spoken with a handful of developers who are pausing their new multifamily projects until they get more certainty regarding interest rates and any future moves by the Fed.
And if rates do stabilize? Multifamily developments might start moving forward again. The problem? New construction won’t start immediately.
“Nothing happens quickly in commercial real estate,” Schmidt said. “Even if rates stabilize or tick down a bit, it will still take time for those processes to be revved up again. There are so many steps before you get to the start of new construction.”
Schmidt said that those multifamily projects that are already under construction or close to starting won’ stop. That’s because of the huge demand for multifamily units across the country.
But a bigger slowdown in multifamily construction might come a year from now, Schmidt said. That’s when the current slate of apartment projects will wrap construction. And because of higher interest rates, there might not be many new apartment projects following.
“The Twin Cities market needs new apartment units,” Schmidt said. “We have a long way to go before web build enough to meet the demand. Then there’s the fact that we are building a lot of new luxury units when what we really need are affordable units. It’s not easy for developers to make the numbers work when it comes to affordable housing.”
Developers typically rely on tax and other financial incentives from governments to make affordable housing projects work. That won’t change in the future, Schmidt said.
“You have to put all the right pieces together,” Schmidt said.
The Inflation Reduction Act helps
Schmall said that the Inflation Reduction Act of 2022 has helped Mortenson find new business. Mortenson does a significant amount of work in the renewable energy business. Thanks to the Inflation Reduction Act, companies have brought manufacturing back to the United States, including manufacturing for the renewables industry.
As Schmall says, these are big jobs, big enough to keep commercial construction firms such as Mortenson busy.
“We are seeing some reshoring today,” Schmall said. “It’s especially true in the solar business. A lot of companies are bringing manufacturing in solar here.”
And while Blizzard said that reshoring hasn’t had a huge impact in the Twin Cities market, some markets, especially those that have embraced the CHIPS and Science Act that that provides new funding to boost domestic manufacturing of semiconductors, are seeing plenty of high-tech manufacturing locate in their states.
“There are some states that are going all in on the CHIPS act,” Blizzard said. “They are committing big dollars to get these projects. Minnesota is talking about this, but there is competition for CHIPS act work all over the country. We have not seen the huge impact here yet.”
Public-sector work has been a boon to Mortenson, too, filling in the gaps from the downturn in private-sector construction jobs.
Blizzard pointed to the impressive amount of K-12 education projects, both new construction and renovations, that Mortenson has taken on as an example of how public-sector work has been a lucrative alternative even as interest rates remain high.
“Even if private development slows down, public development won’t,” Schmidt said. “We are very busy with public work right now. There are a lot of pent-up dollars from the pandemic. In Minnesota, the bonding bill was delayed by a year, but a large bill passed in the spring. There is a steady stream of public projects thanks to that. We are still early on in that cycle.”
Schmidt said that Stahl has a long history of supplementing its private work with public projects. That helps the company stay steady even when economic challenges slow the flow of private-sector work.
“It is nice to be in both worlds,” she said. “When one world is a bit slow, the other tends to be busy. It’s important to be able to pursue and have experience in both areas.”
Schmidt said that Stahl has been busy with school construction and renovation projects. That’s thanks largely to the number of communities dotting Stahl’s coverage area that continue to grow and need new public-school buildings.
Stahl is also taking on a significant amount of municipal work, including the construction of city hall, fire station and public works buildings.
Waiting for stability
Stahl Construction is also working on the construction of the St. Francis City Hall and Fire Station in St. Francis, Minnesota.
It’s unlikely that interest rates will ever dip back to the lows the country saw in 2020 through 2022. But Schmall said that what the commercial real estate industry needs is stability when it comes to interest rates.
This means that construction firms are waiting for the Fed to put an end to the tweaking of its benchmark interest rate, Schmall said.
“What the market hates is uncertainty,” Schmall said. “If it gets to the point where the Fed says that this is enough, that will bring comfort. It’s kind of a fool’s errand now, though, to try to predict whether we’ll see another interest rate hike.”
Blizzard said that the developers in the Twin Cities have already shown that they are ready to jump at new work once interest rates stabilize. He pointed to developers embracing any project that has certainty attached to it, typically public-sector work.
“There is cautious optimism out there,” Blizzard said. “This is a moment in time that we are all monitoring very carefully. The Twin Cities market has always rebounded after slowdowns in the past. It’s more a question of how fast it will rebound, not so much if it will rebound.”
The Twin Cities has long benefited from its more conservative approach to development. Unlike other major markets, the Minneapolis-St. Paul market is not overbuilt in any sector, whether that be multifamily, industrial or retail.
This lack of excess inventory will help the market recover quickly once interest rates stabilize, Schmall said.
The unknown factor, though, is what the office sector will look like in the future. No one knows yet what the workplace of the future will look like and when, or if, most employees will return to the office on a full-time basis.
That variable is something that the commercial development and construction businesses have not had to deal with in the past.
“We talk about this quite a bit,” Schmall said. “That is one element of the market that is different this time around. There are quite a few buildings in the CBD that are lightly occupied. What is that going to do? Fortunately, we have not been uber aggressive or risky when it comes to new development. We don’t get too far over our skis.”
Some office buildings with high vacancy rates will probably be repositioned, turned into other uses such as multifamily. But as Blizzard said, not every struggling office property can be turned into an apartment. Such conversions are expensive and don’t make sense for every building.
“We can’t leave buildings empty forever,” Blizzard said. “But we are all in the middle of figuring out which buildings work and how to repurpose them. Repositioning old office buildings, though, can be part of what gets the market bouncing again.”
Not all asset types created equal
Today’s interest-rate environment hasn’t hit all asset types as hard. As Schmall says, housing and industrial remain active, especially on the leasing side where demand for these property types is still high.
The demand for new advanced manufacturing facilities continues to rise, too. Companies seemingly have an insatiable appetite for data center space.
Then there is the healthcare sector, which Schmall says has rebounded solidly since the days of the COVID pandemic.
“Healthcare took a dip during the pandemic, but now it is getting stronger again,” Schmall said. “We are now seeing healthcare organizations with pent-up demand to do things. They are moving forward with their projects. Healthcare has been pretty strong for us in Minneapolis.”
Stahl had built plenty of hotel properties in the past, Schmidt said. But new construction in the hospitality has slowed, especially in the Midwest.
This slowdown can be traced to a lack of business travel. Leisure travelers have returned and are filling up hotel rooms. But conferences, cross-country meetings and other forms of business travel remain down, slowing the demand for new hotel construction.
“We are starting to see a few more hotel renovation projects pop up, but we are still not seeing many new construction projects in this sector,” Schmidt said. “The business travel is going to remain depressed for the near future. The future of hotels, then, is largely dependent on vacation travelers. If that keeps ticking up, we will start to see new construction rebound in the hospitality sector.”
The challenge of higher construction costs
Interest rates aren’t the only challenge that construction pros face today. The industry is still dealing with higher materials costs, which makes completing new construction projects more expensive.
Schmidt said that this will be a long-term challenge: She doesn’t see construction costs falling by much.
“Once materials costs have gone up, they might go down a little, but they won’t go back to where they were,” Schmidt said. “And labor costs are not going to go back down. We also have a labor shortage. Labor is still in the driver’s seat in terms of demanding what they want to work. If people are waiting for construction costs to go down significantly, that probably won’t happen.”
Like other commercial construction companies, Stahl is also delaying with materials delays. It still takes longer to get certain materials to the job site.
This means that construction companies need to plan their jobs carefully, mapping out every step of the building process, Schmidt said.
“This has required owners and design teams to choose their systems very early on in the process,” Schmidt said. “That way, these materials can be pre-ordered. You have to fund those systems early on.”
Schmidt said that switchgears and electrical equipment still have long lead times, largely because there are fewer suppliers of these items.
“You have to get in line when you need these items,” Schmidt said.
