Rising Construction Costs Versus Interest Rates: Both Hurt, But In Different Ways

WASHINGTON, DC—Talk about the irony of timing—or should that be the inescapable grip of market supply and demand? At any rate, on Wednesday the American Institute of Architects announced that the Architecture Billings Index reached its highest level since 2007 in July with a score of was 55.8, up markedly from 53.5 in June. The bottom line conclusion, according to AIA chief economist Kermit Baker? "Business conditions for the design and construction marketplace, and those industries associated with it, appear to be well-positioned for continued growth in the coming months."

Just in time, as it happens, for accelerating construction costs. Over the past few days we have been looking at twin threats to the commercial real estate industry—the almost sure likelihood of rising interest rates and the rapid ascent of construction prices. Interest rates hikes are coming, but they are not here yet, while construction increases are. With that as background we asked a number of readers which was worse. A behavioral scientist might opt for the construction costs: those are happening now, while the pain of future rate hikes are still unrealized. And many respondents did agree-they are worse. But others are more leery of rate hikes. Read on to see the reasoning in both camps.

***

Count Steve Fifield, chairman and CEO of Chicago-based Fifield Cos., as most worried about rising construction costs. He doesn't believe the Fed will raise rates until 2015. Meanwhile, construction bids are 8-10% higher than six months ago, he tells GlobeSt.com. "That concerns us most. We're already building in 5-7 year term borrowing rates at 5.5-6% for projects that stabilize in 2016 and beyond versus today's 3.5-4.4% rates."

Lydia Stefanowicz, partner at Edwards Wildman Palmer, also leans towards construction costs as worse of two bad options, mainly because rates are so low and will remain low even as they start to rise, if all signs of the Fed can be trusted.

Rapidly increasing construction costs, however, have made it very difficult to hold to construction budgets from the point of planning to substantial completion, she tells GlobeSt.com. "A lot of the costs increases are attributable to shortages resulting from a failure by suppliers to anticipate increased demand for building products and from increased use of just-in-time inventory policies that are based on post-2008 demand patterns, rather than inherent shortages of building materials."

That is, she says, it's a planning problem as much as anything. But Stefanowicz offers this caveat at the end: if interest rates were to rise notably or rapidly, that would have a much greater impact on the CRE markets than the current rise in construction costs because of the number of pending and anticipated refinancings this year.

Lawrence Goldstein, senior vice president at NAI Hunneman, a commercial real estate brokerage firm based in Boston, as well sees rates as a far off worry; meanwhile the cost of raw materials, production, and transport of product will continue to rise as demand increases. However, he tells GlobeSt.com, it's important to remember that it doesn't take much for that to reverse and the market to have a glut of material. For example, copper recently saw a spike in pricing, an increase in supply, and a resulting decrease in cost. Similarly, the current overproduction of oil will ultimately cause a decrease in the price."

There are good reasons, though, to fear rising interest rates more, some of our respondents said.

Peter Muoio, chief economist at Auction.com, tells us that in the longer term, interest rate increases could begin to impede commercial real estate valuation growth. "This will vary substantially by segment and market however, as different segments and markets now sit at varying cap rate spreads versus treasuries: those with tighter cap rate spreads will be at greater risk for cap rate increases in a rising rate environment, potentially limiting valuation gains, especially in instances where NOI growth slows as occupancies approach very high levels."

There is also this Muoio says: rising rates could offer better options for investors then the relatively attractive yields that real estate currently offers. Higher rates in short, could give investors a broader spectrum of higher yielding assets.

Finally, Dean Pappas, a partner in Goodwin's Real Estate Capital Markets Group reminds us that interest rates ultimately set asset valuations reducing the return thresholds used to determine price and valuations. "If interest rates and cap rates go up then necessarily all real estate should go down in value unless you have cash flow growth at the property level, such as higher rents."

***

Come back tomorrow as we wrap up this series.

Read part 1 here.

Read part 2 here.