Interest Rates and Construction: Where Are We Now?
It’s been just over a year and a half since the Federal Reserve began increasing interest rates from recent pandemic-era lows in an attempt to help stifle inflation. Rate hikes affect credit, and the Fed's goal is to tighten lending availability in an attempt to slow demand to be more in line with a lower-supply environment, helping to abate inflationary pressures. Right now, Fed interest rates are stabilizIed around 5.5% (up from 3.25% one year ago, and 0.25% in March of 2022). This is after 11 interest rate hikes—the most aggressive rate-hiking strategy ever.
Coupled with strong job growth and consumer spending, rate hikes haven't severely hampered the economy, leading experts to agree that the tactic is working and that inflation will shrink to target rates by the end of 2024. And, recognizing that there’s a need for more data, the Fed has paused rate hikes temporarily before it makes any other moves. But globally, central banks in other countries are continuing to assess their interest rate situations, meaning the tightening effect is world-wide.
What does all of this mean for the construction industry? What is the relationship between interest rates and construction? Here’s a look at the current state of construction and rates from a financial perspective.
The Impact of Interest Rate Hikes on Construction
Few people will argue that inflation wasn’t making life difficult. However, the interest rate hikes designed to combat inflation impacted certain industries more than others. The following are some of the biggest changes the Fed’s decisions have made on the construction industry over the last year and a half.
Tighter Profit Margins
When the interest rates started to climb, so did the cost of borrowing money. Interest rates on the bank loans that so many contractors and firms were used to borrowing started swelling. Paying for these higher rates cut directly into these contractors’ profit margins.
One way to combat these tighter margins would be to charge more for the project. While some contractors did just that, this simply offloads the costs onto owners—another party feeling the squeeze of higher interest rates. When projects became unaffordable, many investors decided to freeze project spending and watch from the sidelines.
Increased Lender Scrutiny and Cash Flow
With interest rates climbing, fewer borrowers headed to banks for loans. That’s bad for the banking business, and as a result, banks had to increase their requirements and scrutiny while scaling back the amount of money they were willing to lend.
Banks started requiring contractors to come to the table with more money in hand, which meant they were willing to lend less to finance projects. Contractors with healthy cash reserves might not have had issues coming up with the funds to secure loans, but the cost of using other people’s money to fund a project climbed just the same.
Using their own cash also directly impacted these contractors’ cash flow. It prevented them from taking on as many projects as they might’ve been able to in the past and made paying suppliers, loans, and employees more difficult.
But Mortgage Rates Didn’t Drop, Either—And That Impacts a Lot
The flip side of mortgage interest rates stabilizing is that they aren’t dropping, either. And that impacts the landscape of residential construction tremendously.
Single-family housing is still in short supply. Homeowners with mortgage rates in the 3% range aren’t anxious to give these notes up for rates north of 7%. As a result, the folks in need of housing who can’t wait for inventory to become available are opting to build their homes—if they have the means.
But, since money isn’t going as far as it used to, what are the concessions? Size. The average size of a new house was about 2,350 square feet in 2021, but it’s closer to 2,200 square feet today. Higher rates are forcing homeowners to cut down the size of their new construction dream homes to make them more affordable so they can borrow less.
Builders are conceding, as well. Many are cutting the prices of the new construction homes they have on the market to increase sales and get these homes off their ledgers. Rather than continuing to hold these homes and pay excessive interest rates on loans or accounts, they’re choosing to sell the home quickly for less and simply make less profit.
It’s Only Temporary (Probably)
The rate pause is probably only temporary. The Fed has a plan to quell inflation, and many experts believe that it must stay the course a while longer to prevent reinflation from surging.
The pause is in place because the Fed wants more data before it makes any further decisions. It wants to know more about the impacts the rate hikes have had on the economy. While the plan appears to be holding the interest rates higher for a longer period, the Fed needs more data before it raises rates again and determines a reasonable timeline.