According to a recent report from Marcus & Millichap, the construction industry is going to face some challenges in the coming years due to increased interest rates. The report suggests that this will have a significant impact on commercial real estate development, as it is already facing several issues, such as a tight labor market, rising wages, and increased costs of essential services like housing and food.

The Federal Reserve has increased interest rates, which currently stand at 4.75 percent – the highest level recorded since December 2007 – in response to these challenges. However, despite a decline in shipping costs, average prices of steel and gasoline in recent quarters, construction material costs remain high, exacerbating the situation. This combination of higher interest rates and elevated building costs is making it tough for the commercial real estate construction sector.

Although projects that have already started or secured financing are still moving forward, many factors are limiting new development starts. Banks are executing fewer construction loans due to increased risk exposure, and lenders are tightening underwriting. If developers secure loans, they come at rates well-above measures recorded before the health crisis. Additionally, material costs for developers are still 33.5 percent higher than pre-pandemic levels, and wage growth in the construction sector is registering 5.8 percent, outpacing the private sector average. This has resulted in fewer new construction starts and is expected to slow future development.

The industrial sector is one of the hardest-hit areas, with supply chain disruptions and changes in consumer spending habits driving a significant rise in new products. Although supply additions are expected to reach a two-decade high in 2023, a slowdown in development is anticipated. Construction starts have already declined by roughly 40 percent in the fourth quarter of 2022 compared to the previous three-month span. Amazon, which accounted for roughly 16 percent of all warehouse starts over the past three years, recently announced plans to halt new construction, leading to fewer deliveries in the future.

The retail and office construction sectors are also expected to slow down. Although 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 are showing signs of deceleration, and construction starts this year for both property types are expected to decline. The increased prevalence of online and omnichannel shopping has changed the demand for brick and mortar retail, while work-from-home trends have spurred a decline in office usage rates.

However, developers remain optimistic about multifamily projects. Despite the challenges mentioned earlier, the apartment sector continues to see record inventory growth, and completions in 2023 are expected to reach the 400,000 unit mark for the first time in over 30 years. Furthermore, multifamily project starts during February of this year reached the second-highest monthly measure in three decades, indicating momentum is not slowing for new construction in the sector. The ongoing national housing shortage and steep barriers to homeownership are increasing developers’ confidence, and will likely continue to drive the development of new communities in the near- to mid-term.

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