Challenging times. That’s what the industrial sector is facing today in the Minneapolis-St. Paul market. The culprits? High interest rates, of course.
This doesn’t mean that the Twin Cities-area industrial market is at a standstill. There’s still great demand from end users looking for industrial space throughout the region. That isn’t changing. What is slowing are industrial sales and new development, again thanks to high interest rates.
We spoke with Paul Hyde, co-founder of Minneapolis’ Hyde Development, about the challenges that developers face in today’s high-interest-rate environment. Here is what he had to say.
I’ll start with a broad question: How have high interest rates impacted the development of new industrial projects throughout the Twin Cities market?
Paul Hyde: Quite frankly, it’s been terrible. Typically, whether you are talking about an acquisition or new construction, developers take on 60% to 70% debt on a project. When so much of a project’s development is financed by loans, when interest rates move it has a significant effect on whether you can get that project done. A year ago, the rates were dramatically lower. And 18 months ago, they were even lower. The higher interest rates have had a cascading effect on industrial development.
Higher interest rates also drive depositors to take their money out of banks and invest it in something like a U.S. Treasury bond, which might be the safest investment in the world. They are almost paying 10% on the 10-year bond. If the banks, then, don’t have the deposits they can’t lend the money. As a result, people aren’t starting new buildings because they can’t get loans. They aren’t buying buildings because they can’t get loans.
We have counted on the superregional and regional banks to provide financing for real estate projects, whether new construction or acquisition. Now that banks have no money and aren’t lending, there is no money available for developers to start new projects or for investors to buy existing projects.
Then the loans on the banks’ books aren’t getting turned over. The loan they made two years ago on a project isn’t getting sold or refinanced. This basically means that the primary entity that finances commercial real estate, the regional and superregional banks, are on the sidelines. In the capital markets piece, the plumbing is clogged, someone said. That’s a great explanation.
Are you hopeful that the Fed might be done with its rate hikes, or nearly done?
Hyde: Whenever we get a little window of activity – we had a couple, one in January and another in early summer – and we think things are getting better, another jobs report comes out or a war starts in Gaza. If there was a deal you were working on and rates move violently again it blows those deals up.
For us, we are not starting any new projects. It’s not for a lack of leasing activity. It’s just hard to finance a project when interest rates are in the 6% or 7% range when two years ago they were at 3%. And when we do go after acquisitions and we make a bid, the rates keep rising. As rates rise, our price goes down and the sellers pull the properties off the market because they are so frustrated with the low offers they are receiving. They remember the prices they were getting a year or two ago.
Are there any indications that these challenges will lessen in the near future?
Hyde: That’s hard to say. On the building sales side we didn’t see much industrial product in the Twin Cities market during the first six months of the year. During the last two or three months, people have said that we might have seen the last rate increase from the Fed, things are starting to get better. We need to sell buildings and sell them now. Then the jobs report comes out and it’s not what people wanted to see, and rates keep going up. Buyers are saying that the prices they were offering in June or July are no longer possible because of that, so the owners don’t sell.
I do think rates will eventually go down. We do hear from the experts who say that will happen next year. There is a presidential election coming up. There will be lots of political pressure to lower rates before the election. For us, we are trying to ride it out until 2025. That’s what we are thinking.
2025? That’s a long time away
Hyde: It is a long time. We are fortunate because we have a business plan. We keep our buildings. We are still collecting rents and operating our buildings. That side of the business is doing great. We are just not developing anything new. Most development companies focus on building and selling buildings. That model is strained in these times where there is no activity.
All that being said, this was needed and healthy. We were coming through a time in 2021 and 2022 when our costs to build a building went up 21% each year. The cost to build an industrial building went up 42% in those two years. I’d never seen that in my life. We couldn’t get switchgear, roof supplies, all the guts of a building. That, by and large, has been corrected. Cost escalations have flattened out. Lead times are better. That needed to happen. In that sense, these interest rate increases have helped.
The leasing activity is still strong. There will be more demand for industrial space with no new construction coming. That will lead to a much brighter market in 2025 and going forward. We have to focus on the future and the fundamentals while suffering through what is happening today.
Leasing activity is still strong throughout the industrial market?
Hyde: Yes. We have a project in Eagan called The Waters that we bought a year ago. We have been renewing some tenants and leasing up some vacancy. That project is so active, it is hard to keep track of the tenants that are coming in to see the space. It is going well. We are fortunate that we bought this building at the right time and fortunate that our interest rate on that loan is a good one, that the fundamentals of the leasing market are still going well.
We are hopeful, based on the data we are seeing, that leasing activity will fill up whatever buildings are out there. The amount of new industrial construction will go down dramatically. That will lead to an increase in rental rates and demand for new construction when the rates do start to come down.
The Twin Cities industrial market has been strong for a long time. What are some of the reasons for this?
Hyde: I have done this for 25 years. Historically, the diversity of our economy is what makes our market so strong. We aren’t captive to just one business or one industry. The diversity of the group of businesses and industries here is what drives our leasing market. We have never been a market that overheats like you see on the coasts. We have a much healthier industrial market than other markets that threw up multiple million-square-foot distribution centers without any tenants based on a surge in ecommerce after COVID. That surge didn’t justify as much new industrial construction as some markets put up.
Historically, we have not had that overbuilding of spec space that you’ve seen in other markets. We were headed there, frankly, last fall. There was 10-million-plus square feet of spec construction planned or on the way. With these interest rates, those projects have been put on hold, which was appropriate. There are still a couple of big spec projects that were designed poorly and not appropriate for the Twin Cities by out-of-town developers that need to get filled up. But they’ll fill up. Our conservative approach to development will help us recover faster.